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BASEL II AND CONTAINING RISK

BANKS IN INDIA have recently been asked by the Reserve Bank of India to adopt, by March 31, 2007, a new, proactive, approach towards risk management as laid down by the Basel Committee on Bank Supervision, an internationally recognised body of bank supervisors based in the Swiss city of that name. The details of the new regulatory framework, which closely follow what are referred to as Basel II norms, are displayed on the RBI's website and will be of immediate relevance to banks and their regulators. Customers of banks and other laypeople will be more interested in evaluating the practical benefits of what promises to be a more stable financial sector once the norms are implemented. In countries with sound banking traditions including India, financial sector supervisors and banks have long followed risk-minimising practices; while appearing rudimentary in hindsight, these safeguards provided a decent measure of financial sector stability for the less challenging times. Indeed risk management, by whatever name called, has been basic to the banking business, which is more leveraged than any other comparable business. Banks create a multiplier effect by lending (and investing) more than what their level of deposits would normally permit. It is in that context that banking regulators hit upon the idea of asking banks to adjust their capital (the other critical component alongside deposits on the liabilities side of their balance sheets) in line with their risks profile. The more risks a bank took on, the more it had to provide for by way of capital and reserves. This fairly elementary dictum has been the cornerstone of banking sector regulation over the decades.

In a globalising age, with banks dealing extensively with customers and banks in other countries, it became obvious that the supervisory strategies of particular countries had to be dovetailed to the requirements of a global strategy. Since 1988, banks in India and a hundred other countries have followed what is now referred to as the Basel I standard — a set of regulatory rules designed to cope with the growing uncertainty in the global financial system. The immediate provocation was the spectacular failure in 1974 of the German bank, Bankhaus Herstatt, with disastrous consequences to banks and institutions on either side of the Atlantic. The Herstatt failure prompted international cooperation among bank supervisors on an unprecedented scale covering a number of areas. Basel I has been quite simple to follow. However, it seemed to adopt a `one size fits all' approach that was found wanting as supervisory complexities grew. Besides, the earlier approach did not segregate the different types of risk banks were required to take on top of the well-recognised credit risk, that is, the chances of a borrower defaulting. Risks relating to interest rate and foreign exchange volatility and other operational matters needed to be quantified and measured and ways found to contain them.

The new Basel II norms address these two deficiencies. A multi-pronged strategy will recognise all types of risks and comprise measures to contain them. The new approach also recognises the need to supplement regulatory stipulation of capital adequacy requirements — still the first pillar of a more comprehensive framework — with other tools. Better regulation and inculcating market discipline among banks have come to be recognised as equally important; they constitute the second and the third pillars. The three mutually reinforcing elements, it is hoped, will pave the way for a superior risk containment strategy. The relevance of all this to India is obvious. Many Indian banks are going global and those that will continue to be domestic players exclusively cannot remain isolated from a rapidly globalising system.

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