For the last two years RBI has been looking ahead and preparing the ground for advance steps towards eventual implementation of Basel II accord by the Indian Banking System. In the Monetary and Credit Policy for the year 2003-04 announced by the Governor Dr.Bimal Jalan 29th April 2003 before the release of document CP3 by Basel Committee, this viewpoint of RBI is expressly stated under paragraphs 123 & 124 as reproduced hereunder:

"124. The New Capital Accord, presently under consideration of the Basel Committee, aims at capturing major risks inherent in a bank's operations and envisages enhancement of risk sensitivity. In order to equip banks to identify, measure, monitor and control the various types of risks assumed by them, RBI has, over a period, issued various guidelines and guidance notes taking into account the overall ability of banks to adopt them. The Reserve Bank has also taken a number of proactive steps and rationalised various prudential norms to prepare banks to understand the complexity and lessen the burden of costs involved in adhering to the international standards. These steps include phased provisioning, building up of investment fluctuation reserve (IFR) to guard against interest rate risks, refining asset-liability management systems with tolerance levels, assessing the impact of the proposed New Capital Accord on banks by conducting quantitative impact studies (QIS), relaxing exposure norms and permitting concessional risk weights in critical areas of importance and putting in place a sound 'know your customer' (KYC) policy and adopting antimoney laundering measures.

"125. Taking into account the preliminary results of the QIS, the Basel Committee is fine-tuning risk weights assigned to banks' exposures to retail customers, small and medium enterprises (SMEs), residential mortgages, securitisation transactions, past due loans etc., reflecting the risk characteristics of these exposures. The Basel Committee is also considering entrusting the supervisors with discretion for estimating capital charge for operational risk appropriate to risk profile of the bank."

After publication of the document CP3, the third consultative document on 30.04.2003, RBI reviewed the different recommendations of the draft document in the background of their eventual implementation by the banking system in India and submitted its comments. This document titled "Comments of the Reserve Bank of India on the Third Consultative Document of the New Basel Capital Accord" can viewed in the website of RBI.

The overall approach of RBI in formulating its comments is stated as under:

"The Reserve Bank of India (RBI) had forwarded its comments on the Second Consultative Paper (CP 2) of the New Basel Capital Accord to the Basel Committee on Banking Supervision (the Committee) in May 2001 and had also placed it on its website. RBI recognises that several of the concerns expressed and suggestions made by India and other emerging markets on the second consultative paper have been taken into account and addressed in the third Consultative Document (CP 3) after consultations and conducting a Quantitative Impact Study (QIS 3). Particularly, the provision of a Simplified Standardised Approach which provides for calculating risk-weighted assets, provision of preferential risk weights for retail exposures (75%) and residential mortgages (35%), aligning the capital requirements for credit risk in the trading book with the banking book and partial adoption of different approaches under the operational risk, reflect the Committee's endeavour in evolving a consensus which would facilitate adoption of the New Capital Accord in many jurisdictions.

"However, some of the issues relevant in the context of the emerging markets and developing countries are yet to be fully addressed. In its attempt to strive for more accurate measure of risks in banks, the simplicity of the present Capital Accord is proposed to be replaced, with a highly complex methodology which needs the support of highly sophisticated MIS/ data processing capabilities. The complexity and sophistication essential for banks for implementing the New Capital Accord restricts its universal application in the emerging markets. Banks in these emerging markets form a significant segment in financial intermediation and are likely to find implementation of the New Capital Accord a major challenge in the medium term. Besides banks, supervisors would be required to invest considerable resources in upgrading technology systems, and human resources to meet the minimum standards. Banks in emerging markets would, therefore, face serious implementation challenges due to lack of adequate technical skills, under development of financial markets, structural rigidities and less robust legal system.

"The QIS 3 results for the Standardised Approach show an increase in capital requirements for all country groupings in respect of both Group 1 and Group 2 banks. The QIS 3 results from the participating non-G-10 countries show that overall increase in risk weighted assets under the Standardised Approach was 19%, reflecting the impact of new operational risk charge (+ 15%) plus a credit risk contribution (+ 4%). These average contributions fall to + 11% and + 2% respectively (or an overall increase of around 13%) after some recalibration to the risk weights attached to claims on retail portfolios, residential property and past due loans.

"The Reserve Bank of India is fully committed to implement the best international practices. However, the level of preparedness of the banking system and the supervisors would vary from country to country. In view of this, it will be desirable to assign greater flexibility to national supervisors to calibrate risk weights on different types of exposures under the Standardised Approach. For example, the CP 3 has recalibrated the risk weights on claims on retail portfolio to 75% and residential property to 35%. The CP 3 has also indicated reduction in risk weights on past due loans from 150% to 100% or 50%, depending on the level of provisions held against such loans and to encourage banks to make higher provisions for past due loans by providing capital relief. RBI welcomes such adaptability in the approach shown in CP 3. RBI also notes that the national supervisors can consider a higher risk weight on unrated claims on corporates if warranted in their jurisdictions. However, RBI feels that there are many other areas in which national supervisors can be allowed greater flexibility in assigning a lower risk weight if the country-specific situation so warrants than following a "one-size-fits-all" approach based on the external ratings under the Standardised Approach. RBI has examined the various aspects of the proposals contained in the CP 3 and conveyed its specific comments thereon in this document"

By way of summarising its comments RBI has stated under title "Conclusions" in the aforesaid document as under:

"6 Conclusion

"6.1 RBI welcomes the adaptability in approach shown in CP 3. RBI also notes that the national supervisors can consider a higher risk weight on unrated claims on corporates if warranted in their jurisdictions. However, RBI feels that there are many other areas in which national supervisors can be allowed greater flexibility in assigning a lower risk weight if the country-specific situation so warrants than following a "one-size-fits-all" approach based on the external ratings under the Standardised Approach.

"6.2 The Committee's proposal to apply the New Accord to all 'internationally active banks' within the G-10 countries by end-2006 and permit a longer lead time for banks in the non-G-10 countries acknowledges the need for adopting a flexible approach in the implementation of the New Accord. As the main objective of the New Accord is to ensure competitive equality and providing a reasonable degree of consistency in application, it is necessary that all supervisors across the world should have a common definition of 'internationally active banks'. Hence, the Committee may evolve this definition.

"6.3 The QIS 3 results show that even under the Standardised Approach, which is likely to be adopted by most of banks in the emerging economies, there are

• sizeable increases in credit risk charges for bank exposures as also for sovereign exposures

• the impact of lower risk weights for retail exposures was on average less than expected

• the increase in risk weight to 150% for past due loans was also significant.

"In view of the above, it may be necessary to review the relevant provisions of CP 3 with respect to the Standardised Approach.

"6.4 The proposal to allow banks to adopt an alternative exposure indicator for retail and commercial banking under the Alternative Standardised Approach for calculating operational risk capital charges should reckon only performing advances in these two business lines rather than the total portfolio of loans and advances, which would imply a substantial increase in capital charge for operational risk. The Committee may also like to review the beta factor proposed under the above approach where the banks are unable to disaggregate their gross income into the various business lines, with a view to incentivise banks to migrate from the Basic Indicator Approach to more advanced approaches for measuring operational risk.

6.5 RBI appreciates the Committee's efforts in evolving the New Accord containing proposals that are comprehensive in coverage. When implemented, these would go a long way in making the capital allocation more risk-sensitive and use of supervisory oversight with market discipline would reinforce the supervisory framework and ensure financial stability. However, the complexity and sophistication of the proposals restricts its universal application in emerging markets, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals. Like the 1988 Capital Accord, the New Accord should also preserve the spirit of simplicity and flexibility to ensure universal applicability including emerging markets. The New Accord would involve shift in direct supervisory focus away to the implementation issues. Further, banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet the minimum standards. The increasing reliance on external rating agencies in the regulatory process would undermine the initiatives of banks in enhancing their risk management policies and practices and internal control systems. The minimum standards set even for the IRB foundation approach are complex and beyond the reach of many banks."

It is of interest to point out that even in the U.S.A. the perceived complexities in the New Accord is taken into consideration and U.S. regulators have decided as under:

"U.S. bank regulators issued an Advance Notice of Proposed Rule-making in July regarding implementation of Basel II in the United States.....Under the proposal, only the top 10 largest, internationally active banks will have to comply with the new risk-based capital standard and its sophisticated internal ratings-based approach that is used to determine appropriate capital for credit risk. The regulators have suggested that other institutions may choose to opt-in if they can meet the requirements of the advanced approach and estimated another 10 to 15 banks will do just that. All other U.S. banks and thrifts will remain subject to Basel I."

[Source: from an article titled "Basel II: A High-Risk Proposition" by Casey-Landry, Diane published in online journal "Community Banker"; Sep 2003, Vol. 12 Issue 9, p8, 2p]

In further elaboration of her vierwpoint Ms.Diane Casey-Landry, president and chief executive officer of America Community Bankers, the author, has stated in the article as under:

"We believe that the new standard will raise significant competitive problems for community banks. The most recent Quantitative Impact Study shows that the main area of activity where minimum capital requirements will change substantially is the retail portfolio, where risk weights would be lowered significantly relative to the current accord. Even with an additional operational risk capital requirement, retail-oriented institutions will see a reduction in overall capital requirements under Basel II. This raises serious competitive issues for our members."

Specific comments of RBI conveyed to the Basel Committee for changes/modifications/clarifications in the accord are discussed in the succeeding articles.