Basel II and Credit Risk Management
(Inaugural address delivered by Shri V. Leeladhar, Deputy Governor, Reserve Bank of India at the Taj Holiday Village, Goa, India on September 15, 2007) Mr. Gordy, Mr. Bhattacharya, distinguished participants, ladies and gentlemen, I am delighted to be with you this morning at the inaugural of the third programme in the series being organised under the aegis of the Centre for Advanced Financial Leaning (CAFL) on the theme of Basel II and Credit Risk Management. I am indeed thankful to the organisers for providing me this valuable opportunity to share my thoughts on this very topical subject with this august audience – which, needless to say, has a pivotal role to play in implementing the Basel II framework in the Indian banking system. In fact, this programme itself, which has been tailor made for the whole-time directors of the Indian banks, signifies the importance the RBI attaches to sensitising the top management of the banks to the conceptual constructs underpinning the new framework. 2. I am inclined to believe that the Basel II framework is no longer a novelty for most of you. While the technical aspects of credit risk management in the Basel II environment will be covered during the course of this two-day seminar, I would like to present a brief bird’s eye view of the evolution of the capital adequacy norm for the banks over the decades so as to put the new framework in perspective, the imperatives that led to its refinement in the form of Basel II, the expectations of the RBI from the banking system during the implementation phase and beyond, and the issues and challenges facing us that will need to be addressed in implementing the new framework in a non-disruptive manner. The evolution of capital standards
3. It is interesting to note that till the 1980s, the risk-weighted approach to capital adequacy was not in vogue but the bank’s capital was measured through the traditional gearing ratios. During the 1980s, the increasing competition amongst the international banks and rapid growth in their assets had led to concerns about their deteriorating capital levels. This concern was aggravated by the debt crisis in some of the emerging markets. While the national authorities and regulators in many countries began exhorting their banks to improve their capital ratios, it was realised that varying approaches to capital measurement across countries made international comparisons difficult and there was a need to evolve an internationally consistent approach to capital measurement. Moreover, the market developments by the mid-1980s, coupled with the regulatory pressures for improving the capital ratios for the on-balance sheet activities of the banks, had also witnessed a phenomenal growth in the banks’ off-balance sheet business – which, at that time, was not subject to regulatory capital charge. In this background, the efforts were intensified in 1986 to evolve a common and risk-weighted approach to capital measurement rather than the traditional gearing measure. During 1987, the “Basle Committee on Banking Regulations and Supervisory Practices”, as it was then named, arrived at a consensus on 8% as the minimum capital adequacy ratio. After a period of consultation with the banks around the world, this framework was formally adopted in 1988 and was widely endorsed by the supervisory community, world-wide. This standard came to be commonly known as the Basel Accord or Basel I Framework. It was the first ever attempt at harmonising the banks’ capital standards across the countries, for securing greater international competitive equality and to obviate regulatory capital as a source of competitive inequality. 4. The Accord, in its original form, addressed only the credit risks in the banks’ operations. It was only in 1996 that an amendment was made to cover the market risks also. The Accord had adopted a risk-sensitive approach for making the banks’ capital more responsive to the...
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