Basle Committee on Banking Supervision (BCBS) is a panel consisting of member countries of G-10 (industrialised countries of the world) whose main function is to regulate and set standards for banking operations world-wide. Most of the countries of the world, including Pakistan adopt and follow various standards and pronouncements issued by the BCBS.
The committee issued a document regarding capital measurement standard commonly known as "Basle II" in June 2004 which is a new capital adequacy concept. It should be noted that Basle II is not a mandatory regime but a consensus has grown world-wide that Basle II should be adopted by the end of 2006 but not later than the end of the year 2007. Non-member countries are encouraged to adopt these standards by the end of the year 2008 or even beyond.
Pakistan has decided to adopt Basle II and the central bank (the State Bank of Pakistan or SBP) has in this connection issued an implementation plan vide BSD circular No 3 dated the 31st March, 2005.
As stated above, since the adoption of Basle II is not mandatory even for member countries, in USA the Securities and Exchange commission has announced that only its top seven banks will implement this accord. China has decided only selective adoption of the new accord.
Banking transactions are a special class of business where special regulations are needed to protect the interest of the depositors. In other types of business like manufacturing, trading and services, corporate entities are mainly concerned and focused on protecting the interest of shareholders. But in a corporate entity doing banking business, the main focus is on providers of funds in the shape of deposit (known as depositors).
This is due to the reason that debt/equity ratio is extremely high (sometimes as high as 80 %) in a bank as compared to a normal entity, which exposes depositors to unforeseen losses. Therefore, maintenance of adequate capital level is a must for any bank to ensure that it has a sufficient buffer against unforeseen losses which are not uncommon in a banking business.
This is because of the fact that an overwhelming majority of banking business is "promise based." The adequate level of capital is generally prescribed/monitored by the regulatory authorities in a country(usually by its central bank), which may be defined as "regulatory capital".
If no regulatory capital is prescribed by the regulatory authorities, the risk that, an unnecessarily high level of capital will jeopardise share holders interest in the long term and an imprudently low level of capital will adversely affect the banks' solvency (including depositors and shareholders interest) cannot be ruled out.
Prior to the introduction of "Basle II", Basle I was the benchmark for determining regulatory capital for banks world wide. However, banking failures even in developed economies and some with other considerations forced the BCBS to introduce Basle II because Basle I did not differentiate the various risk profile of assets. No consideration was given to credit risk, including concentration risk and liquidity risk etc, and there was no capital allocation for "operational risk".
Basle II provides a comprehensive regime for capital allocation/bench marking which is more risk averse as compared to Basle I against "credit risk" and "operational risk".
Further, it requires banks to establish an adequate and strong "Risk Management" framework. It encourages those banks who have in place a good risk management regime and penalises those banks who do not manage their risk profile appropriately by requiring higher capital.
The timeframe, issued by the SBP for implementation of different policy segments, is as follows:
Preparation of internal plans to reach SBP before 30.06.2005 specifying that the bank/DFI concerned is willing to adopt the Basle II regime and plans for moving to a particular approach.
Standard Approach for handling "Credit Risks" and Basic Indicators/Standardised Approach for "operational risk" to be adopted from 01.01.2008.
Internal Rating Based (IRB) approach to be adopted from 01.01.2010.
Banks/DFIS interested in adopting "IRB approach" against credit risk before 01.01.2010 may contact SBP. They are required to adopt a parallel run of one and a half years for "Standardised Approach" and two years for "IRB Approach" from 01.07.2006 and 01.01.2008 respectively.
Basle II regime consists of three parts commonly known as "Three Pillars" of the Accord. Pillar I deals with the "minimum requirement" and prescribes the capital allocation mechanism against credit and operational risks". In Pillar I, the capital adequacy requirement of risk weighted capital of 8% as in Basle I is retained; however, the method of calculation for risk weighted average has been changed.
Pillar II describes the supervisory role (of central bank) for reviewing whether Banks/DFIS have adequate capital against their risk profiles. Banks must put in place a comprehensive and proper risks management frame work for allocating adequate capital against those risks.
Further, the supervisor (the central bank) has to review adequacy or otherwise of risk management system and capital allocation functions in the bank against major risks, like liquidity, concentration and interest rate risks, which are not covered under Pillar I. Pillar III sets out disclosure requirements depending upon which particular "approach" banks adopt for calculating minimum capital requirement. In nutshell, the Basle Accord is based on three mutually reinforcing pillars:
-- Minimum capital requirements
-- Supervisory review process
-- Disclosure and market discipline
Pillar I requirements clearly show the need for improvement in the areas of credit risk and operational risk by banks.
Pillar II requirements will substantially change the nature and scope of supervisory review. It will be necessary for supervisors to change their approach and revisit their capabilities for evaluating credit and operational risks for assessing data quality (submitted by banks) and for reviewing related management process.
This will lead to capacity building by the supervisor(s) in their own set-up. SBP has already started capacity building process. Pillar III dealing with disclosure requirements will mean a significant increase in the level of disclosures by Bank / DFIS.
Commercial banks as compared to other types of business operate on a highly-geared capital or on a highly leveraged basis. This phenomenon makes a bank's major functions (the granting of loans to firms and individuals) a highly risky activity.
Operating mainly with the resources of others requires the bank management to be especially risk averse but lending function requires acceptance of risk. In short, bank management should select the "optimum risk/benefits relationship" of any loan proposal.
Commercial banks face extensive set of risk categories like credit risk, operational risk liquidity risk, portfolio risk or concentration risk, industry risk, country risk, foreign exchange risk, interest rate risk etc.
SOME OF THE RISK CATEGORIES ARE DEFINED BELOW IN BRIEF:
LIQUIDITY RISK: This risk is present when a bank's liquid assets (like cash, cash equivalents and other assets that can easily be converted into cash without the bank having to suffer loss on their conversion) are not sufficient to meet the bank's short-term obligations.
In such a scenario, the bank may find itself "locked in" or unable to meet its obligations without converting its liquid assets at a loss.
PORTFOLIO RISK OR CONCENTRATION RISK: Portfolio risk is the risk associated with the structure of banks loan portfolio.
INDUSTRY RISK: It refers to the risk associated with the activities of specific spheres of economic activity like textile industry, engineering industry, steel industry etc.
COUNTRY RISK: Country risk relates to the political and economic climate found in foreign countries in which a bank operates or has an exposure.
A particular country's credit ratings issued by international rating agencies (like Standard and Poor, Moody's Services Inc, Fitch etc) are consulted by banks while taking exposure.
FOREIGN EXCHANGE RISK: Foreign exchange risk may be defined as the "risk of loss" due to changes in the value of foreign currencies in terms of a bank's domestic currency. It only affects those banks who are involved in the buying, selling or holding of foreign exchange assets.
INTEREST RATE RISK: This may be defined as the variability of returns or prices of financial assets caused by changes in interest rates. Interest rates risk is equated with uncertainty relating to the timing and direction of future changes in interest rates.
Basle II mainly concentrates on "credit risk" and "operational risk" and provides a mechanism of capital allocation against these risks. Every bank must develop a mechanism for allocating capital against these two risks.
Top management (including Board of Directors) in the initial stage should concentrate on capacity building, training and putting in place a system of evaluating, recognising and allocating capital against credit risk and "operational risk". For smaller banks, this may pose difficulty.
MANAGING CREDIT RISK: "Credit or Default Risk" is the risk to the lending bank arising from inability of the borrower to meet the terms of loan agreement during the period in which the loan is outstanding.
The terms mainly relate to the repayment of principal and interest when due.
A borrower's inability or unwillingness to meet loan obligations may be due to:
-- A failure to generate enough cash flows.
-- Unrealistic forecast of a borrower's revenue and profit generation capabilities used as the basis for loan.
-- Inadequate market value and/or lack of liquidity of the loan's collateral.
-- Flaws in borrower's business skill.
-- Flaws in borrower's character.
-- Important initial criteria related to the possibly of a future default include.
CHARACTER: Borrower's willingness and determination to meet loan obligations must be evaluated through interviews, background checks both personal and business.
CAPACITY: Borrower's ability to generate cash from total operations.
CAPITAL: Borrower's equity profile and his willingness to contribute equity to the proposal for which loan is requested. Generally, banks insist on a certain debt equity ratio depending on the nature of business.
CONDITION: The Current state and outlook of the local, regional and national economy and that of the borrower's industry or trade.
COLLATERAL: Underlying and pledge security in the form of physical security or a guarantee may help offset weakness. Bankers generally insist on personal security of the borrower together with inquiry on the personal assets. Quality, legality and market value of the collateral are important issues to be looked into.
Borrower's financial statements (duly audited) for the last three years must be obtained and an in-depth analysis of ratios on (i) liquidity, (ii) leverage, (iii) efficiency, (iv) coverage, and (v) profitability should be done for knowing the financial strength or otherwise of the borrower.
All the above factors (risks) must be adequately evaluated before granting loan to a borrower and must be consistently monitored during the loan tenure. The risks of default include but are not limited to these alone. The risk identification must be an ongoing process and open to review at a reasonable time gap.
The best practice is to have the top management (Board) approval for all the new products and services and a periodic review of existing risk management framework by the internal and external auditors. The results of review should at least be quarterly communicated to the Board of Directors.
Capital requirement calculation against "credit risk" is elaborate and risk sensitive. A bank capital ratio will be calculated by dividing the total capital by the sum of risk-weighted assets of credit risk. A standardised approach is considered more suitable for calculation of credit risk in small and medium seized Banks.
Big banks with advanced risk management framework can make use of "Inter Rating-Based" (IRB) approach. In order to minimise and quantify "credit risk" a sound, adequate and effective "Internal Risk Management Frame-work", supported by an efficient management information system (MIS), should be in place.
(To be concluded)
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