Are Indian Banks Ready for Basel II ?

As the days approaching for the implementation of Basel II in India, it becomes important evaluating the impact of the norms on Indian banking system.

As per RBI guidelines, Indian banks having foreign branches and foreign banks operating in India will have to adopt the regulations under Basel II by March 31, 2008. Except local area banks and regional rural banks, all the other commercial banks will have to migrate to Basel II by March 31, 2009.

After the implementation of these norms(more on these norms here ), banks will have to adopt Standardised Approach for credit risk and Basic Indicator Approach for operational risk for computing their capital requirements for these risks. In the later stage banks can move to Internal Rating-Based approach for credit risk and Advanced Measurement or Standardised Approach for operational risk with due permission from RBI.

Bank in India are going to witness significant impact on credit risk weight and operational risk weight with the implementation of Basel II. The norm provides an opportunity to Indian banks to reduce the required regulatory capital for credit risk by reducing the credit risk weight. As the RBI has lowered the credit risk for retail exposure to 75% as against current risk weight of 125% for personal/credit card loans and 100% for other loans, bank can change their portfolio accordingly to minimise the regulatory capital and increase their business. Apart from this, Indian banks have large short term portfolio which includes cash credit, overdraft and working capital demand loans, which are currently unrated and hence carry a risk weight of 100%. The RBI guidelines for short term investment provide for lower risk weights and that gives further reduction in the regulatory capital reserve. Hence this norm does bring an opportunity for Indian banks to reduce their credit risk weights and reduce their required regulatory capital. But, looking at the operational risk, the Basic Indicator Approach specifies a capital charge of 15% of annual positive gross income over the past three years, which does not help banks in reducing the required capital for operational risk.

The NPA has largely been reduced by provisioning for bad debt or by infusion of capital from government or other sources. But, with the implementation of Basel II norms, banks would need more capital and it would have to arrange for capital outside of their own or the government resources. In ICRA’s estimates, Indian banks would need additional capital of up to 120 billion Rs to meet the capital requirement for operational risk. Looking at the asset growth witnessed in the past and the expected growth trend, the capital charge requirement for operational risk will grow by 15-20% annually over three years. To meet this additional capital, large number of banks have been forced to turn to capital market with IPOs and FPOs. This further has its own impact on the banking structure as it demands for dilution of government ownership on these banks. Government was forced to increase the FDI limit by 74% in banking sector to help these banks raise the required capital. These moves in the sector have grown pressure to consolidate domestic banks to make them capable of facing international competition. Given the significant dominance of foreign banks over the domestic counterparts, even after the consolidation of domestic banks the threat of takeover remains if the FDI limit is further relaxed.

Thus, the large scale presence of foreign banks and consolidation of Indian banks are inevitable post Basel II.