1

ABSTRACT

This project report studies the relationship between two most basic elements of business Risk
and Capital. These elements are the subject matters of the New Capital Accord established by the
Basel Committee for Banking Supervision (BCBS).
The banking industry also follows the old adage we live life forward but learn it backward.
There have been many cases of bank failures in the past the cause of which can be assigned to
rash risk-taking, imprudent investments, frauds and inadequate internal control. Banks being one
of the most important financial institutions of any country, the collapse of any bank has adverse
and far-reaching social impact for that country. Not only that, with the advent of globalization in
banking, it becomes even more imperative to closely relate economic and regulatory capital and
enhance transparency.
Thus, the BASEL norms ensure that capital is more risk sensitive, there is a clear demarcation of
operational risk, credit risk, and other risks which can have an impact on the operations of the
bank and there is transparency of risk levels at which the bank is operating.
Though the norms are meant to be a recommendation, the central banks of most countries are
making it mandatory to adhere to these norms. Some banks in India have switched to the new
norms from year ended 31
st
March, 2008 and the rest will move over by 31
st
March, 2009.
However well defined the norms are, there are complex challenges involved in adhering to the
norms purposefully.
This report gives a glimpse into the adoption of BASEL II norms in one of most reputed global
banks BNP Paribas (India office). It also addresses the complexities involved, challenges faced
and benefits derived from adoption of these norms by banks in India.
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OBJECTIVE OF THE SUMMER PROJECT

This project has been undertaken with following objectives in mind:
To understand the theory of Capital Accord (old and new) as given by the BCBS.

To comprehend the impacts of the new norms on the functioning of the banking
industry in India.

To understand how these norms are put to practice. This involves understanding of the
coalition of input data, the process of data sorting, computing according to the norms,
assessing different stress scenarios and the final output of such computations. It also
involves close observation of the problems faced in implementation.

To draw a parallel of this situation to the banking industry as a whole.












3

Banking System in India & Basel Norm

Introduction

The Banking system in India is significantly different from that of other Asian nations because of
the countrys unique geographic, social, and economic characteristics. India has a large
population and land size, a diverse culture, and extreme disparities in income, which are marked
among its regions. There are high levels of illiteracy among a large percentage of its population
but, at the same time, the country has a large reservoir of managerial and technologically
advanced talents. Between about 30 and 35 percent of the population resides in metro and urban
cities and the rest is spread in several semi-urban and rural centers.
The countrys economic policy framework combines socialistic and capitalistic features with a
heavy bias towards public sector investment. India has followed the path of growth-led exports
rather than the exported growth of other Asian economies, with emphasis on self-reliance
through import substitution. These features are reflected in the structure, size, and diversity of
the countrys banking and financial sector. The banking system has had to serve the goals of
economic policies enunciated in successive five-year development plans, particularly concerning
equitable income distribution, balanced regional economic growth, and the reduction and
elimination of private sector monopolies in trade and industry. In order for the banking industry
to serve as an instrument of state policy, it was subjected to various nationalization schemes in
different phases (1955, 1969, and 1980). As a result, banking remained internationally isolated
(few Indian banks had presence abroad in international financial centers) because of
preoccupations with domestic priorities, especially massive branch expansion and attracting
more people to the system. Moreover, the sector has been assigned the role of providing support
to other economic sectors such as agriculture, small-scale industries, exports, and banking
activities in the developed commercial centers (i.e., metro, urban, and a limited number of semi-
urban centers). The banking systems international isolation was also due to strict branch
licensing controls on foreign banks already operating in the country as well as entry restrictions
facing new foreign banks. A criterion of reciprocity is required for any Indian bank to open an
office abroad.
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These features have left the Indian banking sector with weaknesses and strengths. A big
challenge facing Indian banks is how, under the current ownership structure, to attain operational
efficiency suitable for modern financial intermediation. On the other hand, it has been relatively
easy for the public sector banks to recapitalize, given the increases in nonperforming assets
(NPAs), as their Government dominated ownership structure has reduced the conflicts of interest
that private banks would face.

History of Banking in India

Without a sound and effective banking system in India, it cannot have a healthy economy. The
banking system of India should not only be hassle free but it should be able to meet new
challenges posed by the technology and any other external and internal factors. For the past three
decades India's banking system has several outstanding achievements to its credit. The most
striking is its extensive reach. It is no longer confined to only metropolitans or cosmopolitans in
India. In fact, Indian banking system has reached even to the remote corners of the country. This
is one of the main reasons of India's growth process. The government's regular policy for Indian
bank since 1969 has paid rich dividends with the nationalization of 14 major private banks of
India. Not long ago, an account holder had to wait for hours at the bank counters for getting a
draft or for withdrawing his own money. Today, he has a choice. Gone are days when the most
efficient bank transferred money from one branch to other in two days. Now it is simple as
instant messaging or dial a pizza. Money has become the order of the day. The first bank in
India, though conservative, was established in 1786. From 1786 till today, the journey of Indian
Banking System can be segregated into three distinct phases.
They are as mentioned below:
Early phase from 1786 to 1969 of Indian Banks
Nationalization of Indian Banks and up to 1991 prior to Indian banking sector Reforms.
New phase of Indian Banking System with the advent of Indian Financial & Banking Sector
Reforms after 1991.
To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II and Phase III.









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Phase I
The General Bank of India was set up in the year 1786. Next came Bank of Hindustan and
Bengal Bank. The East India Company established Bank of Bengal (1809), Bank of Bombay
(1840) and Bank of Madras (1843) as independent units and called it Presidency Banks. These
three banks were amalgamated in 1920 and Imperial Bank of India was established which started
as private shareholders banks, mostly Europeans shareholders.
In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab National
Bank Ltd. was set up in 1894 with headquarters at Lahore. Between 1906 and 1913, Bank of
India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore
were set up. Reserve Bank of India came in 1935. During the first phase the growth was very
slow and banks also experienced periodic failures between 1913 and 1948. There were
approximately 1100 banks, mostly small. To streamline the functioning and activities of
commercial banks, the Government of India came up with The Banking Companies Act, 1949
which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No.
23 of 1965). Reserve Bank of India was vested with extensive powers for the supervision of
banking in India as the Central Banking Authority. During those days public has lesser
confidence in the banks. As an aftermath deposit mobilization was slow. Abreast of it the savings
bank facility provided by the Postal department was comparatively safer. Moreover, funds were
largely given to traders.

Phase II
Government took major steps in this Indian Banking Sector Reform after independence. In 1955,
it nationalized Imperial Bank of India with extensive banking facilities on a large scale especially
in rural and semi-urban areas. It formed State Bank of India to act as the principal agent of RBI
and to handle banking transactions of the Union and State Governments all over the country.
Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on 19th July,
1969, major process of nationalization was carried out. It was the effort of the then Prime
Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in the country were
nationalized. Second phase of nationalization Indian Banking Sector Reform was carried out in
1980 with seven more banks. This step brought 80% of the banking segment in India under
Government ownership.
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The following are the steps taken by the Government of India to Regulate Banking Institutions in
the Country:
1949: Enactment of Banking Regulation Act.
1955: Nationalization of State Bank of India.
1959: Nationalization of SBI subsidiaries.
1961: Insurance cover extended to deposits.
1969: Nationalization of 14 major banks.
1971: Creation of credit guarantee corporation.
1975: Creation of regional rural banks.
1980: Nationalization of seven banks with deposits over 200 crore.
After the nationalization of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%. Banking in the
sunshine of Government ownership gave the public implicit faith and immense confidence about
the sustainability of these institutions.

Phase III
This phase has introduced many more products and facilities in the banking sector in its reforms
measure. In 1991, under the chairmanship of M. Narasimham, a committee was set up by his
name which worked for the liberalization of banking practices. The country is flooded with
foreign banks and their ATM stations. Efforts are being put to give a satisfactory service to
customers. Phone banking and net banking is introduced. The entire system became more
convenient and swift. Time is given more importance than money. The financial system of India
has shown a great deal of resilience. It is sheltered from any crisis triggered by any external
macroeconomics shock as other East Asian Countries suffered. This is all due to a flexible
exchange rate regime, the foreign reserves are high, the capital account is not yet fully
convertible, and banks and their customers have limited foreign exchange exposure.





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Banks in India
In India the banks are being segregated in different groups. Each group has their own benefits
and limitations in operating in India. Each has their own dedicated target market. Few of them
only work in rural sector while others in both rural as well as urban. Many even are only catering
in cities. Some are of Indian origin and some are foreign players. All these details and many
more are discussed over here. The banks and its relation with the customers, their mode of
operation, the names of banks under different groups and other such useful information are
talked about. One more section has been taken note of is the upcoming foreign banks in India.
The RBI has shown certain interest to involve more of foreign banks than the existing one
recently. This step has paved a way for few more foreign banks to start business in India.


Major Banks in India

ABN-AMRO Bank State Bank of Bikaner & Jaipur
Abu Dhabi Commercial Bank China Trust Commercial bank
American Express Bank Citi Bank
Andhra Bank City Union Bank
Allahabad Bank Corporation Bank
Bank of Baroda Dena Bank
Bank of India Deutsche Bank
Bank of Maharashtra Development Credit Bank
Bank of Punjab Dhanalakshmi Bank
Bank of Rajasthan Federal Bank
Bank of Ceylon HDFC Bank
BNP Paribas Bank HSBC
Canara Bank ICICI Bank
Catholic Syrian Bank IDBI Bank
Central Bank of India Indian Bank
Centurion Bank State Bank of Hyderabad
Indian Overseas Bank State Bank of Indore
IndusInd Bank State Bank of Mysore
ING Vysya Bank State Bank of Saurastra
Jammu & Kashmir Bank State Bank of Travancore
JPMorgan Chase Bank Syndicate Bank
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Karnataka Bank Taib Bank
Karur Vysya Bank UCO Bank
Laxmi Vilas Bank Union Bank of India
Oriental Bank of Commerce United Bank of India
Punjab National Bank United Western Bank
Punjab & Sind Bank Axis/UTI Bank
Scotia Bank Vijaya Bank
South Indian Bank
Standard Chartered Bank
State Bank of India (SBI)



















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Banking services in India:-
With years, banks are also adding services to their customers. The Indian banking industry is
passing through a phase of customers market. The customers have more choices in choosing
their banks. A competition has been established within the banks operating in India. With stiff
competition and advancement of technology, the service provided by banks has become more
easy and convenient. The past days are witness to an hour wait before withdrawing cash from
accounts or a cheque from north of the country being cleared in one month in the south. This
section of banking deals with the latest discovery in the banking instruments along with the
polished version of their old systems.

Reserve Bank of India (RBI)

The central bank of the country is the Reserve Bank of India (RBI). It was established in April
1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton
Young Commission. The share capital was divided into shares of Rs. 100 each fully paid which
was entirely owned by private shareholders in the beginning. The Government held shares of
nominal value of Rs. 2, 20,000. Reserve Bank of India was nationalized in the year 1949. The
general superintendence and direction of the Bank is entrusted to Central Board of Directors of
20 members, the Governor and four Deputy Governors, one Government official from the
Ministry of Finance, ten nominated Directors by the Government to give representation to
important elements in the economic life of the country, and four nominated Directors by the
Central Government to represent the four local Boards with the headquarters at Mumbai,
Kolkata, Chennai and New Delhi. Local Boards consist of five members each.
Central Government appointed for a term of four years to represent territorial and economic
interests and the interests of co-operative and indigenous banks. The Reserve Bank of India Act,
1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides the statutory basis
of the functioning of the Bank.
The Bank was constituted for the need of following:
To regulate the issue of banknotes
To maintain reserves with a view to securing monetary stability and
To operate the credit and currency system of the country to its advantage.

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o Functions of Reserve Bank of India:

The Reserve Bank of India Act of 1934 entrust all the important functions of a central bank the
Reserve Bank of India.

Bank of Issue

Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank
notes of all denominations. The distribution of one rupee notes and coins and small coins all over
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the country is undertaken by the Reserve Bank as agent of the Government. The Reserve Bank
has a separate Issue Department which is entrusted with the issue of currency notes. The assets
and liabilities of the Issue Department are kept separate from those of the Banking Department.
Originally, the assets of the Issue Department were to consist of not less than two-fifths of gold
coin, gold bullion or sterling securities provided the amount of gold was not less than Rs. 40
crores in value. The remaining three-fifths of the assets might be held in rupee coins,
Government of India rupee securities, eligible bills of exchange and promissory notes payable in
India. Due to the exigencies of the Second World War and the post-was period, these provisions
were considerably modified. Since 1957, the Reserve Bank of India is required to maintain gold
and foreign exchange reserves of Ra. 200 crores, of which at least Rs. 115 crores should be in
gold. The system as it exists today is known as the minimum reserve system.


Banker to Government

The second important function of the Reserve Bank of India is to act as Government banker,
agent and adviser. The Reserve Bank is agent of Central Government and of all State
Governments in India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business, via. to keep the cash balances as deposits free of
interest, to receive and to make payments on behalf of the Government and to carry out their
exchange remittances and other banking operations. The Reserve Bank of India helps the
Government - both the Union and the States to float new loans and to manage public debt. The
Bank makes ways and means advances to the Governments for 90 days. It makes loans and
advances to the States and local authorities. It acts as adviser to the Government on all monetary
and banking matters.

Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. According to the provisions of the Banking
Companies Act of 1949, every scheduled bank was required to maintain with the Reserve Bank a
cash balance equivalent to 5% of its demand liabilities and 2 per cent of its time liabilities in
India. By an amendment of 1962, the distinction between demand and time liabilities was
abolished and banks have been asked to keep cash reserves equal to 3 per cent of their aggregate
deposit liabilities. The minimum cash requirements can be changed by the Reserve Bank of
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India. The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible
securities or get financial accommodation in times of need or stringency by rediscounting bills of
exchange.

Controller of Credit

The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume
of credit created by banks in India. It can do so through changing the Bank rate or through open
market operations. According to the Banking Regulation Act of 1949, the Reserve Bank of India
can ask any particular bank or the whole banking system not to lend to particular groups or
persons on the basis of certain types of securities. Since 1956, selective controls of credit are
increasingly being used by the Reserve Bank.
The Reserve Bank of India is armed with many more powers to control the Indian money
market. Every bank has to get a license from the Reserve Bank of India to do banking business
within India, the license can be cancelled by the Reserve Bank of certain stipulated conditions
are not fulfilled. Every bank will have to get the permission of the Reserve Bank before it can
open a new branch. Each scheduled bank must send a weekly return to the Reserve Bank
showing, in detail, its assets and liabilities. This power of the Bank to call for information is also
intended to give it effective control of the credit system. The Reserve Bank has also the power to
inspect the accounts of any commercial bank.
(a) It holds the cash reserves of all the scheduled banks.
(b) It controls the credit operations of banks through quantitative and qualitative controls.
(c) It controls the banking system through the system of licensing, inspection and calling for
information.
(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official rate of exchange.
According to the Reserve Bank of India Act of 1934, the Bank was required to buy and sell at
fixed rates any amount of sterling in lots of not less than Rs. 10,000. The rate of exchange fixed
was Re. 1 = sh. 6d. Since 1935 the Bank was able to maintain the exchange rate fixed at lsh.6d.
Though there were periods of extreme pressure in favor of or against the rupee. After India
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became a member of the International Monetary Fund in 1946, the Reserve Bank has the
responsibility of maintaining fixed exchange rates with all other member countries of the I.M.F.
Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the
custodian of India's reserve of international currencies. The vast sterling balances were acquired
and managed by the Bank. Further, the RBI has the responsibility of administering the exchange
controls of the country.

Supervisory functions

In addition to its traditional central banking functions, the Reserve bank has certain non-
monetary functions of the nature of supervision of banks and promotion of sound banking in
India. The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949 have given the RBI
wide powers of supervision and control over commercial and co-operative banks, relating to
licensing and establishments, branch expansion, liquidity of their assets, management and
methods of working, amalgamation, reconstruction, and liquidation. The RBI is authorized to
carry out periodical inspections of the banks and to call for returns and necessary information
from them. The nationalization of 14 major Indian scheduled banks in July 1969 has imposed
new responsibilities on the RBI for directing the growth of banking and credit policies towards
more rapid development of the economy and realization of certain desired social objectives. The
supervisory functions of the RBI have helped a great deal in improving the standard of banking
in India to develop on sound lines and to improve the methods of their operation.


Promotional functions

With economic growth assuming a new urgency since Independence, the range of the Reserve
Bank's functions has steadily widened. The Bank now performs variety of developmental and
promotional functions, which, at one time, were regarded as outside the normal scope of central
banking. The Reserve Bank was asked to promote banking habit, extend banking facilities to
rural and semi-urban areas, and establish and promote new specialized financing agencies.
Accordingly, the Reserve Bank has helped in the setting up of the IFCI and the SFC; it set up the
Deposit Insurance Corporation in 1962, the Unit Trust of India in 1964, the Industrial
Development Bank of India also in 1964, the Agricultural Refinance Corporation of India in
1963 and the Industrial Reconstruction Corporation of India in 1972. These institutions were set
up directly or indirectly by the Reserve Bank to promote saving habit and to mobilize savings,
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and to provide industrial finance as well as agricultural finance. As far back as 1935, the Reserve
Bank of India set up the Agricultural Credit Department to provide agricultural credit. But only
since 1951 the Bank's role in this field has become extremely important. The Bank has
developed the co-operative credit movement to encourage saving, to eliminate moneylenders
from the villages and to route its short term credit to agriculture. The RBI has set up the
Agricultural Refinance and Development Corporation to provide long-term finance to farmers.

Classification of RBIs functions
The monetary functions also known as the central banking functions of the RBI are related to
control and regulation of money and credit, i.e., issue of currency, control of bank credit, control
of foreign exchange operations, banker to the Government and to the money market. Monetary
functions of the RBI are significant as they control and regulate the volume of money and credit
in the country. Equally important, however, are the non-monetary functions of the RBI in the
context of India's economic backwardness. The supervisory function of the RBI may be regarded
as a non-monetary function (though many consider this a monetary function). The promotion of
sound banking in India is an important goal of the RBI, the RBI has been given wide and drastic
powers, under the Banking Regulation Act of 1949 these powers relate to licensing of banks,
branch expansion, liquidity of their assets, management and methods of working, inspection,
amalgamation, reconstruction and liquidation. Under the RBI's supervision and inspection, the
working of banks has greatly improved. Commercial banks have developed into financially and
operationally sound and viable units. The RBI's powers of supervision have now been extended
to nonbanking financial intermediaries. Since independence, particularly after its nationalization
1949, the RBI has followed the promotional functions vigorously and has been responsible for
strong financial support to industrial and agricultural development in the country.








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Nature of Banking in India

A banking company in India has been defined in the banking companies act,1949.as one which
transacts the business of banking which means the accepting, for the purpose of lending or
investment of deposits of money from the public, repayable on demand or otherwise and
withdraw able by cheque, draft, order or otherwise.
Most of the activities a Bank performs are derived from the above definition. In addition, Banks
are allowed to perform certain activities which are ancillary to this business of accepting deposits
and lending. A bank's relationship with the public, therefore, revolves around accepting deposits
and lending money. Another activity which is assuming increasing importance is transfer of
money - both domestic and foreign - from one place to another. This activity is generally known
as "remittance business" in banking parlance. The so called forex (foreign exchange) business is
largely a part of remittance albeit it involves buying and selling of foreign currencies.


Functioning of a Bank:-

Functioning of a Bank is among the more complicated of corporate operations. Since Banking
involves dealing directly with money, governments in most countries regulate this sector rather
stringently. In India, the regulation traditionally has been very strict and in the opinion of certain
quarters, responsible for the present condition of banks, where NPAs are of a very high order.
The process of financial reforms, which started in 1991, has cleared the cobwebs somewhat but a
lot remains to be done. The multiplicity of policy and regulations that a Bank has to work with
makes its operations even more complicated, sometimes bordering on illogical. This section,
which is also intended for banking professional, attempts to give an overview of the functions in
as simple manner as possible. Banking Regulation Act of India, 1949 defines Banking as
"accepting, for the purpose of lending or investment of deposits of money from the public,
repayable on demand or otherwise and withdraw able by cheques, draft, and order or otherwise."
Deriving from this definition and viewed solely from the point of view of the customers, Banks
essentially perform the following functions:
Accepting Deposits from public/others (Deposits)
Lending money to public (Loans)
Transferring money from one place to another (Remittances)
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Acting as trustees
Keeping valuables in safe custody
Government business
Banks are organized in a linear structure to performed these activities at the base of which
lies a Branch. The corporate office of a bank is normally called Head Office.
Kinds of Banks
Financial requirements in a modern economy are of a diverse nature, distinctive variety and large
magnitude. Hence, different types of banks have been instituted to cater to the varying needs of
the community. Banks in the organized sector may, however, be classified in to the following
major forms:
1. Commercial banks
2. Co-operative banks
3. Specialized banks
4. Central bank


Commercial Banks:-

Commercial banks are joint stock companies dealing in money and credit. In India, however
there is a mixed banking system, prior to July 1969, all the commercial banks-73 scheduled and
26 non-scheduled banks, except the state bank of India and its subsidiaries-were under the
control of private sector. On July 19, 1969, however, 14 major commercial banks with deposits
of over 50 Crores were nationalized. In April 1980, another six commercial banks of high
standing were taken over by the government. At present, there are 20 nationalized banks plus the
state bank of India and its 7 subsidiaries constituting public sector banking which controls over
90 per cent of the banking business in the country.




Co-operative Banks:-
Co-operative banks are a group of financial institutions organized under the provisions of the Co-
operative societies Act of the states. The main objective of co-operative banks is to provide
cheap credits to their members. They are based on the principle of self-reliance and mutual co-
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operation. Co-operative banking system in India has the shape of a pyramid a three tier structure,
constituted by:
Primary credit societies [APEX]
Central co-operative banks [District level]
State co-operative banks [Villages, Towns, Cities]


Specialized Banks:-

There are specialized forms of banks catering to some special needs with this unique nature of
activities. There are thus,
1. Foreign exchange banks,
2. Industrial banks,
3. Development banks,
4. Land development banks,
5. Exim bank.

Central Bank:-

A central bank is the apex financial institution in the banking and financial system of a country.
It is regarded as the highest monetary authority in the country. It acts as the leader of the money
market. It supervises, control and regulates the activities of the commercial banks. It is a service
oriented financial institution.
Indias central bank is the reserve bank of India established in 1935.A central bank is
usually state owned but it may also be a private organization. For instance, the reserve bank of
India (RBI), was started as a shareholders organization in 1935, however, it was nationalized
after independence, in 1949.it is free from parliamentary control.







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Role of Banks in a Developing Economy

Banks play a very useful and dynamic role in the economic life of every modern state. A study of
the economic history of western country shows that without the evolution of commercial banks
in the 18th and 19th centuries, the industrial revolution would not have taken place in Europe. The
economic importance of commercial banks to the developing countries may be viewed thus:
1. Promoting capital formation
2. Encouraging innovation
3. Monetsation
4. Influence economic activity
5. Facilitator of monetary policy
Above all view we can see in briefly, which are given below:



Promoting capital formation:-


A developing economy needs a high rate of capital formation to accelerate the tempo of
economic development, but the rate of capital formation depends upon the rate of saving.
Unfortunately, in underdeveloped countries, saving is very low. Banks afford facilities for saving
and, thus encourage the habits of thrift and industry in the community. They mobilize the ideal
and dormant capital of the country and make it available for productive purposes.


Encouraging innovation:-


Innovation is another factor responsible for economic development. The entrepreneur in
innovation is largely dependent on the manner in which bank credit is allocated and utilized in
the process of economic growth. Bank credit enables entrepreneurs to innovate and invest, and
thus uplift economic activity and progress.


Monetsation:-


Banks are the manufactures of money and they allow many to play its role freely in the economy.
Banks monetize debts and also assist the backward subsistence sector of the rural economy by
extending their branches in to the rural areas. They must be replaced by the modern commercial
banks branches.

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Influence economic activity:-


Banks are in a position to influence economic activity in a country by their influence on the rate
interest. They can influence the rate of interest in the money market through its supply of funds.
Banks may follow a cheap money policy with low interest rates which will tend to stimulate
economic activity.


Facilitator of monetary policy:-

Thus monetary policy of a country should be conductive to economic development. But a well-
developed banking system is on essential pre-condition to the effective implementation of
monetary policy. Under-developed countries cannot afford to ignore this fact. A fine, an efficient
and comprehensive banking system is a crucial factor of the developmental process.






















20

Principles of Bank lending policies

The main business of banking company is to grant loans and advances to traders as well as
commercial and industrial institutes. The most important use of banks money is lending. Yet,
there are risks in lending. So the banks follow certain principles to minimize the risk:

[[

Safety:-

Normally the banker uses the money of depositors in granting loans and advances. So first of all
initially the banker while granting loans should think first of the safety of depositors money.
The purpose behind the safety is to see the financial position of the borrower whether he can pay
the debt as well as interest easily.

Liquidity:-
It is a legal duty of a banker to pay on demand the total deposited money to the depositor. So the
banker has to keep certain percent cash of the total deposits on hand. Moreover the bank grants
loan. It is also for the addition of short term or productive capital. Such type of lending is
recovered on demand.

Profitability:-

Commercial banking is profit earning institutes. Nationalized banks are also not an exception.
They should have planning of deposits in a profitability way pay more interest to the depositors
and more salary to the employees. Moreover the banker can also incur business cost and can give
more benefits to customer.

Purpose of loan:-
Banks never lend or advance for any type of purpose. The banks grant loans and advances for the
safety of its wealth, and certainty of recovery of loan and the bank lends only for productive
purposes. For example, the bank gives such loan for the requirement for unproductive purposes.


Principle of diversification of risks:-

While lending loans or advances the banks normally keep such securities and assets as a supports
so that lending may be safe and secured. Suppose, any particular state is hit by disasters but the
bank shall get benefits from the lending to another states units. Thus, he effect on the entire
business of banking is reduced. There are proverbs that do not keep all the eggs in one basket
21

Retail Banking-the new flavor

The Concept of Retail Banking:-

The concept of Retail banking is not new to banks. It is only now that it is being viewed as an
attractive market segment, which offers opportunities for growth with profits. The diversified
portfolio characteristic of retail banking gives better comfort and spreads the essence of retail
banking lies in individual customers. Though the term Retail Banking and retail lending are often
used synonymously, yet the later is lust one side of Retail Banking. In retail banking, all the
banking needs of individual customers are taken care of in an integrated manner.


Retail Lending Products:-


Major retail lending products offered by banks are the following:

I. Housing Loans
II. Loan for Consumer goods
III. Personal Loans for marriage, honeymoon, medical treatment and holding etc.
IV. Education Loans
V. Auto Loans
VI. Gold Loans
VII. Event Loans
VIII. Festival Loans
IX. Insurance Products
X. Loan against Rent receivables
XI. Loan against Pension receivables to senior citizens
XII. Debit and Credit Cards
XIII. Global and International Cards
XIV. Loan to Doctors to set up their own Clinics or for purchase of medical equipments
XV. Loan for Woman Empowerment for the Setting up of boutiques
XVI. Loan for purchase of acoustic enclosures for Diesel Gen. Sets etc.




22

Retail Banking Products for Depositors:-
Retail banking products for depositors in various segments of customers like; children, salaried
persons. Senior citizens, professionals, technocrats, businessmen, retail traders and farmers etc.
include:
a. Flexi deposit Accounts
b. Savings Bank Accounts
c. Recurring Deposit Accounts
d. Short Term Deposits
e. Deferred pension Linked Deposit Schemes


Other Retail Banking Services:-

Offer of several frills and goodies is not the end of the game. Banks also offer following Retail
Banking services free of charges to customers:
1. Payment of utility bills like water, electricity, telephone and mobile phone bills
2. Payment of insurance premiums on due dates
3. Payment of monthly/quarterly education fee of children to their respective schools
4. Remittance of funds from one account to another
5. Demating of shares, bonds, debentures, and mutual funds
6. Payment of credit card bills on due dates
7. Last but not the least, the filing of income tax returns and payment of income tax

The impact of Retail Banking:-

The major impact of Retail Banking is that, the customers have become the emperors
the fulcrum of all banking activities, both on the asset side and the liabilities front. The
hitherto sellers market has transformed into buyers market. The customers have multiple
of choices before them now for cherry picking products and services, which suit their life
styles and tastes and financial requirements as well. Banks now go to their customers
more often than the customers go to their banks.
The non-banking finance Companies which have hitherto been thriving on retail business
due to high risk and high returns thereon have been dislodged from their profit munching
citadel.
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Retail banking is transforming banks in to one stop financial super markets.
The share of retail loans is fast increasing in the loan books of banks.
Banks can foster lasting business relationship with customers and retain the existing
customers and attract new ones. There is a rise in their service levels as well.
Banks can cut costs and achieve economies of scale and improve their revenues and
profits by robust growth in retail business. Reduction in costs offers a win win situation
both for banks and the customers.
It has affected the interface of banking system through different delivery mechanism.
It is not that banks are sharing the same pie of retail business. The pie itself is growing
exponentially; retail banking has fueled a considerable quantum of purchasing power
through a slew of retail products.
Banks can diversify risks in their credit portfolio and contain the menace of NPAs.
Re-engineering of business with sophisticated technology based products will lead to
business creation, reduction in transaction cost and enhancement in efficiency of
operations.

The Future of Retail Banking:-

Though at present Retail Banking appears to be the best bet for banks to improve their top and
bottom line, yet the future of Retail banking in general, may not be all roses as it appears to be.
There are signs of slowdown in customer growth in some countries, which will inevitably have
an impact on Retail Banking business growth. Secondly the possibility of deterioration in asset
quality cannot be ruled out. With the boom in housing loan market, the sign of overheating has
also started surfacing with potential problem for banks that have not exercised sufficient caution.
Further the pressure on margins is mounting partly because of fierce competition and partly as a
result of falling interest rates environment which has diminished to some extent the endowment
effect of substantial deposit bases from which most retail banks have been deriving benefits. But
banks, which have built a significant retail banking portfolio may fare relatively well in the
current fiscal. Those banks which have a dynamic retail strategy and are well diversified in
products, services and distribution channels and have at the same time managed to achieve a
good level of cost efficiency are the ones that are most likely to succeed in the longer term.
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Strategic issues in Banking services

Strategic Planning: is the process of analyzing the organizational external and internal
environments; developing the appropriate mission, vision, and overall goals; identifying the
general strategies to be pursued; and allocated resources.
Mission is an organization's current purpose or reason for existing.
Vision is an organization's fundamental aspirations and purpose that usually appeals to its
member's hearts and minds.
Goals are what an organization is committed to achieving.
Strategies are the major courses of action that an organization takes to achieves goals.
Resource Allocation is the earmarking of money, through budgets, for various purposes.
Downsizing Strategy signals an organization's intent to rely on fewer resources primarily
human-to accomplish its goals.
Tactical Planning: is the process of making detailed decisions about what to do, which will do
it, and how to do it-with a normal time and horizon of one year or less. The process generally
includes:
Choosing specific goals and the means of implementing the organization's strategic plan,
Deciding on courses of action for improving current operations, and
Developing budgets for each department, division and project.


Strategic issues in banks services are known as or define by these ways, which
are known as,

Non-Performing Assets of the Banking sector:-

Non Performing Asset means an asset or account of borrower, which has been classified by a
bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the
directions or guidelines relating to asset classification issued by The Reserve Bank of India.
After the global financial turmoil in 2008, Indian banks begin the new year with a lurking fear
that their Non Performing Assets would go up with their portfolios coming under severe stress.
There is already a visible strain on consumer, credit card and vehicle loan portfolios and many
banks have taken conscious decision to scale down their advances to risky sectors. Some banks
have also revised their credit growth targets downwards as the year has come to a close.
25

"The ongoing financial crisis has had its toll on export-related sectors like IT, textile and SMEs.
This may indirectly impact banks' asset quality. There is, therefore, a pressing need to ensure
adequate risk-management mechanisms to overcome this challenge," Bank of Baroda's
Chairman and Managing Director M D Mallya told PTI.
Indian banks witnessed a sharp jump in their gross NPAs for the first time in six years in FY08,
compelling many of them to enhance their existing risk assessment tools. Gross NPAs of
commercial banks in FY08 escalated by Rs 6,136 crore (Rs 61.36 billion), according to figures
released by the Reserve Bank. Though there was no need to be unduly alarmed, banks need to
follow certain standard parameters to ensure the quality of their lending portfolios, Mallya said.
A similar view was echoed by ICICI Bank's CEO-elect Chanda Kochhar who said the lender has
taken a conscious decision "to follow certain parameters" to ensure asset quality. Despite
pressures emanating from global financial markets, Indian banks witnessed a healthy 25 to 29
per cent average growth in credit disbursals, primarily in housing, auto and infrastructure loans.
IndusInd Bank's Head of Wholesale Banking Group J Moses Harding supported this view saying
that the present economic downturn has affected the repayment capacities of small firms,
exerting pressure on the banks' lending portfolios. "There is a pressure on SMEs as many of them
are unable to repay their advances in the current scenario. This situation is likely to last in the
short term. Banks need to adjust their risk management mechanisms to face the situation,"
Harding said. Banks witnessed a huge credit demand from their corporate clients who found their
foreign funding sources drying up in the aftermath of the global meltdown which originated with
the subprime-crisis in America in mid-2007. The growth in credit in the industry in 2008 was in
the range of 25 to 29 per cent on account of working capital requirements of small, mid and
large-sized industries, bankers expect an average 25 per cent in their credit in 2009. While
government-owned banks were quick to respond to the recent signals from policy-makers by
reducing interest rates periodically, many private banks are yet to follow suit, mainly owing to
pressure on their margins. Government-owned banks have effected an up to 1 to 1.5 per cent
reduction in their Prime Lending Rates in the recent past heeding calls from the government and
the Reserve Bank to do so in order to ensure a credit pick-up. PLR is the benchmark rate, based
on which private banks lend to their customers.

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Capital Adequacy Ratio (CAR):-
Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR),
is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it
can absorb a reasonable amount of loss and are complying with their statutory requirements
Application of minimum CRAR protects the interest of depositors and promotes stability and
efficiency of the financial system. Current CAR ratio of banks is 8%
Capital adequacy ratio is defined as

Tier I capital is core capital; this includes equity capital and disclosed reserves.
Tier II capital is secondary bank capital that includes items such as undisclosed reserves,
general loss reserves, subordinated term debt, and more.
Where Risk can either be weighted assets ( ) or the respective national regulator's minimum
total capital requirement. If using risk weighted assets,
8%.
The percent threshold (8% in this case, a common requirement for regulators conforming to the
Basel Accords) is set by the national banking regulator.
Use:
Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting
the time liabilities and other risk such as credit risk, operational risk, etc. In the most simple
formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's
depositors or other lenders. Banking regulators in most countries define and monitor CAR to
protect depositors, thereby maintaining confidence in the banking system.
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In terms of capital adequacy ratio, Axis bank had the maximum rise upto 16.88% in Q3, FY
2007-08 from 11.83% a year earlier. ICICI Bank appeared at the second position with an
increase from 13.37% to 15.82% in the current financial year. Other banks which registered a
significant rise in CAR include ING Vysya Bank, whose ratio rose to 12.23% over and above
10.70% in previous year, HDFC Bank from 12.80% to 13.80% and Centurion Bank of Punjab
from 10.50% in the previous fiscal to 11.50% in the current fiscal.
Capital Adequacy Ratio (in %)
BANKS Q3 FY 07-08 Q3 FY06-07
CBOP 11.50 10.50
HDFC Bank 13.80 12.80
ICICI Bank 15.82 13.37
IDBI Bank 13.31 14.09
ING Vysya Bank 12.23 10.70
AXIS Bank 16.88 11.83
Allahabad bank 12.84 12.80
Bank of India 12.54 11.76
Indian Bank 13.51 12.29
Punjab National Bank 14.04 12.90
State Bank of India 12.28 11.86
Union Bank 13.03 13.21
Bank of Baroda 13.51 12.24
Vijaya Bank 12.21 11.31
Average 13.39 12.26
Among the public sector majors, capital adequacy ratio of Bank of Baroda reached 13.51% at the
end of third quarter in the FY 2007-08 as compared to 12.24% in the corresponding period of the
previous year.
Punjab National Bank turned the corners by marking an increase in its CAR against a decline in
the previous financial year. Its capital adequacy ratio dropped to 12.9% from 13.99% in Q3,
2006-07. However, in Q3, 2007-08, it saw an upward trend of 14.04% against 12.90% in the
similar period, last fiscal.
State Bank of India managed to increase its CAR to 12.28% from 11.86%, in contrast to a
decline to 11.86% from 12.49% in the FY 2006-07.
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However few players also experienced a decline in their respective CAR, but they still managed
to remain above the nine per cent limit. Capital Adequacy Ratio of IDBI Bank has decreased to
13.31% from 14.09% at the end of Q3 and Union Bank`s CAR went down to 13.03% from
13.21%.
Bank rate
Bank rate, also referred to as the discount rate, is the rate of interest which a central bank
charges on the loans and advances that it extends to commercial banks and other financial
intermediaries. Changes in the bank rate are often used by central banks to control the money
supply.
Various Uses for the Term "Bank Rate"
The term bank rate is most commonly used by bankers to refer to the Federal Discount Rate of
interest charged to Federally Chartered Savings Banks. The term bank rate is commonly used by
consumers to refer to the current rate of interest given on a savings certificate of Deposit. The
term bank rate is most commonly used by consumers who are interested in either obtaining a
purchase money mortgage, or a refinance loan, when referring to the current mortgage rate.
Types of bank interest rates
Bank rate on a Certificate of Deposit "CD".
Bank Rate on a credit card or other loan
Bank Rate on an automobile or real estate loan
Used to have a close relation with consumers Bank Rate [current rate of interest]. With an
increase in Bankers Bank Rate the Consumers Bank Rate also used to increase. With vast
changes in Bank Financial Structure and with less dependency on Central Bank for financing
customers credit, the control on Bankers Bank Rate has very less impact on Consumers Bank
Rate.

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Cash Reserve Ratio (CRR)
CRR means Cash Reserve Ratio means the amount of cash the bank has to place with the Reserve
Bank for every customer deposit. Banks in India are required to hold a certain proportion of their
deposits in the form of cash. However, actually Banks dont hold these as cash with themselves,
but deposit such case with Reserve Bank of India (RBI) / currency chests, which is considered
as equivalent to holding cash with themselves. This minimum ratio (that is the part of the total
deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve
Ratio. Thus, when a banks deposits increase by Rs100, and if the cash reserve ratio is 9%, the
banks will have to hold additional Rs 9 with RBI and Bank will be able to use only Rs 91 for
investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower is the
amount that banks will be able to use for lending and investment. This power of RBI to reduce
the lendable amount by increasing the CRR makes it an instrument in the hands of a central bank
through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control
liquidity in the banking system. Current CRR ratio as on 3
rd
January 2009 is 5%.
Statutory Liquidity Ratio (SLR)
It means the amount of cash banks have to maintain as liquid cash to meet its day to day cash
demands. Every bank is required to maintain at the close of business every day, a minimum
proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold
and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities
is known as Statutory Liquidity Ratio (SLR). Present SLR is 24%. (reduced w.e.f.
8/11/2008, from earlier 25%) RBI is empowered to increase this ratio up to 40%. An increase in
SLR also restrict the banks leverage position to pump more money into the economy.SLR ratio
as on 8
th
November 2008 is 24%
Repo rate and Reverse Repo rate
Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks
(Central). When the repo rate increases borrowing from RBI becomes more expensive.
Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow
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money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow
money, it reduces the repo rate. Current Repo rate as on 3
rd
January 2009 is 5.5%
Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI.
The RBI uses this tool when it feels there is too much money floating in the banking system. An
increase in the reverse repo rate means that the RBI will borrow money from the banks at a
higher rate of interest. As a result, banks would prefer to keep their money with the RBI.Current
Reverse Repo rate as on 3
rd
January is 4%.
Sub-prime lending
Sub-prime lending usually refers to the practice of giving loans to those who do not qualify for
regular loans at market interest rates because of their poor credit history. Due to the increased
risk associated with the takers, sub-prime loans are offered at a rate higher than market rates.
These loans are risky for both, those who are giving and those who are taking, because these
combine high interest rates, bad credit history, and often, murky financial situations of the takers.
The US Federal Reserve estimates losses of $100-150 billion (Rs3.93-5.89 trillion) so far and
this could be just the tip of the proverbial iceberg. Indian non-banking financial companies
(NBFCs) are in the business of lending unsecured small-ticket loans to so-called subprime
borrowers. Unbridled lending to subprime borrowers by banks in the past few years is now
biting. The loan-loss ratio in loan portfolios in this segment has touched as high as 15 per cent in
the case of some private sector banks. Subprime borrowers belong to economically weaker
sections with monthly income of around Rs 5,000 and pay interest rate as high as 45-50 per cent
on loans ranging up to Rs 50,000. ICICI Banks personal loans portfolio, including subprime
loans, was about Rs 11,200 crore at the end of June 2007. Banks are also witnessing a sharp rise
in defaults in their motorcycle loans portfolios, where the average loan size is less than Rs
50,000. HDFC Bank too is present in the business of providing small ticket loans, but details on
the level of defaults were not available. HDFC Bank has always maintained that its retail NPAs
are in line with the product mix.

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Total Quality management
Total quality management represents a formidable challenge for bank marketers seeking to
understand what makes their bank shine in the eyes of their customers. As banks move from the
realm of quality service into the domain of total quality management, they are asking themselves
some serious questions about the way they do business. Their probing extends beyond sales and
service to include the total management philosophy.
"Banks are opening up their definition of quality management and considering what their
customers expect and experience, rather than just what the bank provides," "There are a lot of
factors that go into total quality that the customer never sees, yet considers important, such as
accuracy in processing or up time for ATMs."
Both internal and external procedures are being examined, measured and improved to deliver
quality service that is consistent throughout the bank. Sometimes referred to as re-engineering or
strategic management, total quality management programs empower employees to participate
more in the decision process. Service quality measurement systems consist of programs that
provide feedback on the type of service being delivered. Two methods banks use are customer
expectation surveys, which help establish sales and service quality direction, and frequent
mystery shops to measure whether quality service is delivered. Implementing a total quality
management program is an ongoing process consisting of many different components. Banks
that have begun such a journey say it is an intense learning process that spans a lifetime.
Those who have launched total quality management programs say they have learned that all
operations within the bank are inter-related and dependent on one another. Quality service is no
longer the job of only the front-line employees, it is everyone's responsibility.
Knowledge Management
Knowledge management can be defined as a systematic and integrative process of co-ordinating
organization-wide activities of acquiring, creating, storing, sharing, diffusing, developing and
deploying knowledge by individual and groups in the pursuit of major organizational goals. It
also involves the creation of an interacting learning environment where organization members
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transfer and share what they know; and apply knowledge to solve problems, innovate and create
new knowledge. More banks and brokers are tapping knowledge management to understand their
businesses and customers, whether it's in tailoring marketing campaigns for specific segments or
to comply with reporting requirements. After automating and centralizing core customer
information, many banks are taking the next step and installing overlay applications to analyze
the reams of data that they've managed to digitize. Providing desktop access to the information
gives senior management, financial advisors and customer service representatives descriptive,
electronic views of historical transactional and general account data.
Banks are using knowledge management or Business intelligence (BI) solutions primarily "to
understand which of their customers and products are profitable and which ones aren't, but also
for portfolio risk management, where they have concentrations of assets that may give rise to
unusual risks." Banks are applying BI platforms to both sell and manage risk. Uses include
everything from scenario-planning to assess whether a consolidation makes sense, to project
performance measurement on specific sales efforts.











33

Innovation in Bank
Innovation drives organizations to grow, prosper and transform in sync with the changes in the
environment, both internal and external. Banking is no exception to this. In fact, this sector has
witnessed radical transformation of late, based on many innovations in products, processes,
services, systems, business models, technology, governance and regulation. A liberalized and
globalize financial infrastructure has provided an additional impetus to this gigantic effort. The
pervasive influence of in formation technology has revolutionalized banking.
Banking has become boundary less and virtual with a 24 * 7 model. Banks who strongly rely on
the merits of relationship banking as a time tested way of targeting and serving clients, have
readily embraced Customer Relationship Management (CRM), with sharp focus on customer
centricity, facilitated by the availability of superior technology. CRM has, therefore, become the
new mantra in customer service management, which is both relationship based and information
intensive.
Risk management is no longer a mere regulatory issue Basel-2 has accorded a primacy of place
to this fascinating exercise by repositioning it as the core of banking. We now see the evolution
of many novel deferral products like credit derivatives, especially the Credit Risk Transfer
(CRT) mechanism, as a consequence. CRT, characterized by significant product innovation, is a
very useful credit risk management tool that enhances liquidity and market efficiency.
Securitization is yet another example in this regard, whose strategic use has been rapidly rising
globally. So is outsourcing.

Some recent innovations in Indian Banking:-

Tandon can, however, usefully cast an eye at one way of shopping without revealing his credit
card number. HDFC Banks Net Safe card is a one-time use card with a limit thats specified,
taken from Tendons credit or debit card. Even if Tandon fails to utilize the full amount within
24 hours of creating the card, the card simply dies and the unspent amount in the temporary card
reverts to his original credit or debit card. Welcome to one of the myriad ways in which bankers
have been trying to innovate. Theyre bringing ATMs, cash and even foreign exchange to their
customers doorsteps. Indeed, innovation has become the hottest banking game in town. Want to
buy a house but dont want to go through the hassles of haggling with brokers and the mounds of
34

paperwork? Not to worry. Your bank will tackle all this. Its ready to come every step of the way
for you to buy a house. Standard Chartered, for instance, has property advisors to guide a
customer through the entire process of selecting and buying a house. They also lend a hand with
the cumbersome documentation formalities and the registration. You can leverage your new
house or car these days with banks like ICICI Bank and Stanchart ready to extend loans against
either, till its about five years old. Loans are available to all car owners for almost all brands of
cars manufactured in India that are up to five years old.
Still, innovation is more evident in retail banking. True, all banks offer pretty much the same
suite of asset and liability products. But its the small tweaking here and there that makes all the
difference. Take, for example, the once staid deposits. Some bank accounts combine a savings
deposit account with a fixed deposit. A sweep-in account, as it is called, works like this: the
account will have a cut-off, say, Rs 25,000; any amount over and above that gets automatically
transferred to a fixed deposit which will earn the customer a clean 2 per cent more than the
returns that a savings account gives. Last month, Kotak Mahindra Bank introduced a variant
of the sweep-in account. If the balance tops Rs 1.5 lakh, the excess runs into Kotaks liquid
mutual fund. Even if the money is there only for the weekend, a liquid fund can earn you a
clean 4.5 per cent per annum, points out Shashi Arora, vice president, marketing, Kotak
Mahindra Bank. Thats not a small gain considering that your current account does not pay you
any interest. And if, meanwhile, you want to buy a big-ticket home theatre system, the minute
you swipe your card the invested sum will return to your account. Theres plenty of innovation
on home loans. ABN Amro sent the home mortgage market afire with its 6 per cent home
loan offering last year. The product offers a 6 per cent interest rate for two years after which the
interest rate is reset in tune with the prevailing market rate. All the other big home loan players
slashed their rates after this was announced. Look too at the home saver product and its variants
from Citibank, HSBC and Stanchart. The interest rate on the loan is determined by the balance
you maintain in the savings account with the bank. The home builder can maintain a higher
balance in his or her savings account and bring down the interest rate on the home loan. The rate
is calculated on a daily basis on the net loan amount. Stanchart claims that since the launch of its
home saver product in April 2002, close to 40 per cent of its customers have chosen it.
Banks are also attempting to reach out to residents of metropolitan cities where people are
pressed for time (what with long commuting hours, traffic jams and both spouses working),
35

beyond conventional banking hours. ICICI Bank, for example, introduced eight to eight
banking hours, seven days of the week, in major cities. Not to be outdone, some of the other
private banks have also done this too. HDFC Bank even has a 24-hour branch at Mumbais
international airport. Several banks are even bringing ATMs to customer doorsteps. ICICI
Bank, State Bank of India and Bank of India now have mobile ATMs or vans that go along a
particular route in a city and are stationed at strategic locations for a few hours every day. This
saves the bank infrastructure costs since it has one mobile ATM instead of multiple stationary
ones. Thats not all. Even money is delivered to customers at home. Kotak Mahindra Bank, a
late entrant into private banking, delivers cash at the doorstep. A customer can withdraw a
minimum of Rs 5,000 and up to a maximum of Rs 2 lakh and get the money at home. And, mind
you, Kotak is not alone. The list of banks offering a similar service includes Citibank, Stanchart,
ABN Amro and HDFC Bank. HDFC Bank brings even foreign exchange, whether travellers
cheques or cash, to your doorstep courtesy its tie-up with Travelex India. All one has to do is call
up the branch or HDFC Banks phone banking number. The banks country head, retail, Neeraj
Swaroop, believes that continuous innovation will always make a difference, with customer
needs changing day by day. But internet banking and shopping have been slow starters, given the
low computer penetration in the country but banks are going all out to get the customer online.
Not only is electronic fund transfer between banks across cities possible through internet banking
today but banks also offer other features that benefit the customer. HDFC Bank, for instance,
has an option called One View on its internet banking site which provides customers a
comprehensive view of their investments and fund movements. Customers can look at their
accounts in six different banks on one screen. These include HDFC Bank accounts and demat
accounts, ICICI Bank, Citibank, HSBC and Standard Chartered Bank accounts, apart from
details of Citibank credit card dues and so on. Banks are also innovating on the company and
treasury operations fronts. In corporate loans, plain loans are passe. Mumbai inter-bank offered
rate (MIBOR)-linked and commercial paper-linked interest rates on loans are common. MIBOR
is a reference rate arrived at every day at 4 pm by Reuters. It is the weighted average rate of call
money business transacted by 22 institutions, including banks, primary dealers and financial
institutions.
The State Bank of India was the first to user in MIBOR-linked loans for top companies. Soon
enough, other banks followed. ICICI Bank carried out the worlds first ever securitization of a
36

micro finance portfolio last year. The bank securitized Rs 4.2 crore for Bharatiya Samruddhi
Finance Ltd. for crop production. Banks, of course, realize that innovation gives them only a first
mover advantage until their rivals catch up. But then, they can console themselves. Isnt
imitation the best form of flattery?

Technology in Banking

Innovation in technology and worldwide revolution in Information and communication
Technology (ICT) have emerged as dynamic sources of productivity growth. The relationship
between IT and banking is fundamentally symbiotic. In the banking sector, IT can reduce costs,
increase volumes, and facilitate customized products; similarly, IT requires banking and
financial services to facilitate its growth. As far as the banking system is concerned, the payment
system is perhaps the most important mechanism through which such interactive dynamics gets
manifested. Recognizing the importance of payments and settlement systems in the economy, we
have embarked on technology based solutions for the improvement of the payment and
settlement system infrastructure, coupled with the introduction of new payment products such as
the computerized settlement of clearing transactions, use of Magnetic Ink Character
Recognition (MICR) technology for cheque clearing which currently accounts for 65 per cent
of the value of cheques processed in the country, the computerization of Government Accounts
and Currency Chest transactions, operationalisation of Delivery versus Payment (DvP) for
Government securities transactions. Two-way inter-city cheque collection and imaging have
been operationalised at the four metros. The coverage of Electronic Clearing Service (Debit
and Credit) has been significantly expanded to encourage non-paper based funds movement and
develop the provision of a centralized facility for effecting payments. The scheme for Electronic
Funds Transfer operated by the Reserve Bank has been significantly augmented and is now
available across thirteen major cities.
The Centralized Funds Management System (CFMS), which would enable banks to obtain
consolidated account-wise and centre-wise positions of their balances with all 17 offices of the
Deposits Accounts Departments of the Reserve Bank, has begun to be implemented in a phased
manner from November 2001.
The consolidation of the existing payment systems revolves around strengthening Computerized
Cheque clearing, expanding the reach of Electronic Clearing Services and Electronic Funds
37

Transfer by providing for systems with the latest levels of technology. The critical elements in
the developmental strategy are the opening of new clearing houses, interconnection of clearing
houses through the INFINET; optimizing the deployment of resources by banks through Real
Time Gross Settlement System, Centralized Funds Management System (CFMS); Negotiated
Dealing System (NDS) and the Structured Financial Messaging Solution (SFMS).
The setting up of the apex-level National Payments Council in May 1999 and the
operationalisation of the INFINET by the Institute for Development and Research in Banking
Technology (IDRBT), Hyderabad have been some important developments in the direction of
providing a communication network for the exclusive use of banks and financial institutions.
Membership in the INFINET has been opened up to all banks in addition to those in the public
sector. At the base of all inter-bank message transfers using the INFINET is the Structured
Financial Messaging System (SFMS). It would serve as a secure communication carrier with
templates for intra- and inter-bank messages in fixed message formats that will facilitate straight
through processing. All inter-bank transactions would be stored and switched at the central hub
at Hyderabad while intrabank messages will be switched and stored by the bank gateway.
Security features of the SFMS would match international standards.
In order to maximize the benefits of such efforts, banks have to take pro-active measures to:
o further strengthen their infrastructure in respect of standardization, high level of security
and communication and networking;
o achieve inter-branch connectivity early;
o popularize the usage of the scheme of electronic funds transfer (EFT); and
o Institute arrangements for an RTGS environment online with a view to integrating into a
secure and consolidated payment system. Information technology has immense untapped
potential in banking. Strengthening of information technology in banks could improve the
effectiveness of asset-liability management in banks. Building up of a related data-base on a
real time basis would enhance the forecasting of liquidity greatly even at the branch level. This
could contribute to enhancing the risk management capabilities of banks.




38

Regulations and compliance
Progressive strengthening, deepening and refinement of the regulatory and supervisory system
for the financial sector have been important elements of financial sector reforms. In the long run,
it is the supervision and regulation function that is critical in safeguarding financial stability.
There is also some evidence that proactive and effective supervision contributes to the efficiency
of financial intermediation. Financial sector supervision is expected to become increasingly risk-
based and concerned with validating systems rather than setting them. This will entail procedures
for sound internal evaluation of risk for banks. As mentioned earlier, bank managements will
have to develop internal capital assessment processes in accordance with their risk profile and
control environment. These internal processes would then be subjected to review and supervisory
intervention if necessary. The emphasis will be on evaluating the quality of risk management and
the adequacy of risk containment. In such an environment, credibility assigned by markets to risk
disclosures will hold only if they are validated by supervisors. Thus effective and appropriate
supervision is critical for the effectiveness of capital requirements and market discipline.
The need for removing multiple regulatory jurisdictions over the cooperative banking sector has
been reiterated on several occasions. In this regard, the Reserve Bank has proposed the setting up
of an apex supervisory body for urban cooperative banks under the control of a high-level
supervisory board consisting of representatives of the Central governments, the State
governments, the Reserve Bank and experts. The apex body is expected to ensure compliance
with prudential requirements and also supervise on-site inspections and off-site surveillance.
Recent developments in certain segments of the financial sector have also brought to the fore
issues relating to corporate governance in banks.
The largest set of consolidated regulations that mandate integrity of data in India are the IT Act
and SEBI's clause 49 for listed companies. These regulations do not currently enforce the kind of
security standards that are common in Europe and the US. In a global economy, however, no
company is an island and India Inc is adopting US and European compliance procedures and
certifications such as Sarbanes Oxley, Safe Harbour, BS, and ISO. Compliance, regulatory or
otherwise, does not directly concern the IT department. In manufacturing for instance,
compliance controls don't really involve system security, and a large part of the quality control
required by authorities cannot be imposed or enforced using IT. Companies that deal with
39

sensitive information, financial services and BPOs, banks, MNC subsidiaries or those with plans
to expand beyond Indian shores are all affected. These will continue to make strides towards
compliance. For the medium scale segment (Rs 100-300 crore turnover), security and audits are
not a priority. This segment is comfortable with public mail servers, and exchanging information
over not very secure connections.

Benchmarking the Indian Banking system by International standards:-
The impetus given to the strengthening of domestic financial systems and the international
financial architecture by the Asian crisis has gathered momentum in recent years. An important
development In this regard has been the move to set up universally acceptable standards and
codes for benchmarking domestic financial systems. Moreover, multilateral assessments of
country performance are increasingly focusing on observance of standards. The IMFs Article IV
consultations, its Financial Sector Stability Assessment and the Reports on Observance of
Standards and Codes of the IMF and the World Bank are indicative of the fact that a countrys
adherence to benchmark standards and codes is being considered integral to the preservation of
international monetary and financial stability. While the process has begun with the predominant
involvement of governments and regulators, the search for standards and codes is progressively
encompassing the private sector with consideration of issues relating to market discipline,
corporate governance, insolvency procedures and credit rights. It is important to recognize that
new standards and codes are not being regarded as final goals but as instruments or enabling
conditions for enhancing efficiency in financial intermediation while ensuring financial stability.
There are three levels at which action is necessary, viz., legal, policy and procedures, and market
practices by participants. Accordingly, the Standing Committee on International Standards and
Codes, set up in December 1999, constituted ten Advisory Groups comprising eminent experts,
generally nonofficial, to bring objectivity and experience into studying the applicability of
relevant international codes and standards to each area of competence.
The Advisory Groups have submitted their reports. They have set out a roadmap for
implementation of appropriate standard and codes in the light of existing levels of compliance,
the cross-country experience, and the existing legal and institutional infrastructure. The Advisory
Group on Banking Supervision has assessed the Indian banking system vis--vis the principles of
40

the Basel Committee on Banking Supervision. It has found the level of compliance to be
generally of a high order.
Thus, in India, we have made considerable progress in the identification of international
standards and codes in relevant areas, expert assessment regarding their applicability, including
comparator country evaluation and building up possible course of action for the future. The next
step is to sensitize all concerned policy makers, regulators and market participants to the
issues involved and to seek the widest possible debate on issues as well as expert assessments
with a view to generating a broad consensus on implementation of a universally recognized set
of codes and standards.

Recent macroeconomic developments and the Banking system
For a greater part of the twentieth century, the role of the financial system was perceived as
mobilizing the massive resource requirements for growth. Since the 1970s and 1980s,
development economics underwent a paradigm shift. The financial system is no longer viewed as
a passive mobiliser of funds. Efficiency in financial intermediation i.e., the ability of financial
institutions to intermediate between savers and investors, to set economic prices for capital and
to allocate resources among competing demands is now emphasized. Developments in
endogenous growth theory since the late 1980s indicate that efficiency in financial
intermediation is a source of technical progress to be exploited for generating increasing returns
and sustaining high growth. These changes have provided the rationale for many developing
countries to undertake wide-ranging reforms of their financial systems so as to prepare them for
their true resource allocation function. As important financial intermediaries, banks have a
special role to play in this new dispensation.
The Indian economy, after exhibiting strong growth during the second quarter of 2008-09, has
experienced moderation in the wake of the global economic slowdown. Although agricultural
outlook remains satisfactory, industrial growth has decelerated sharply and services sector is
slowing. The economic slowdown, during the second quarter vis--vis the first quarter of 2008-
09, was primarily driven by a moderation of consumption growth and widening of trade deficit,
offset partially by an acceleration in investment demand.
The balance of payments (BoP) for the first half of 2008-09 reflected a widening of the current
41

account deficit and moderation in capital flows. Net capital inflows reduced sharply and
remained volatile during 2008-09 with foreign direct investment inflows showing an increase,
while portfolio investments recording a substantial outflow.
The growth of non-food credit remained high during 2008-09, so far, albeit with some
moderation in recent months. Continued high growth in time deposits enabled the banking
system to sustain the credit expansion while the non-banking sources of funds to the commercial
sector declined. The total flow of resources from banks and other sources to the commercial
sector during 2008-09, so far, has been somewhat lower than the comparable period of 2007-08.
According to estimates released by the Central Statistical Organization (CSO) in November
2008, the real GDP growth was placed at 7.6 per cent during the second quarter of 2008-09 as
compared with 9.3 per cent during the corresponding quarter of 2007-08, reflecting deceleration
in growth of industry and services.
In the credit market, lending rates of scheduled commercial banks, which had increased initially,
started declining in December 2008. Yields in the government securities market also came to
soften during the third quarter 2008-09. The Reserve Bank swiftly initiated a series of measures,
which helped to assuage liquidity conditions, while reassuring the market that the Indian banking
system continued to be safe and sound, well capitalized and well regulated.
The various business expectations surveys released recently reflect less than optimistic
sentiments prevailing in the economy. The results of Professional Forecasters Survey conducted
by the Reserve Bank in December 2008 also suggested further moderation in economic activity
for 2008-09.
According to the Reserve Banks Industrial Outlook Survey of manufacturing companies in the
private sector, the business expectations indices based on assessment for October-December
2008 and on expectations for January-March 2009 declined by 2.6 per cent and 5.9 per cent,
respectively, over the corresponding previous quarters.




42

The Transformation of the Indian Banking sector
The financial sector reforms in the country were initiated in the beginning of the 1990s.The
reforms have brought about a sea change in the profile of the banking sector. Deregulation and
the demands of the globalised economy is transforming the Indian banking industry at the speed
of thought. In this metamorphosis- technology, customer service, and consolidation have
emerged as the key parameters for defining performance. Globalization has brought about a
massive change in the attitude and performance of the banking sector in India. Increasing
competition has improved the product range, enhanced delivery channels and quality of service,
lowered costs and kept pressure on the banks to adopt state-of-art technology.
Whether it is the wide distribution network of the public sector banks (PSBs), or the first-mover
technology advantage taken by the private banks, this new age of banking has brought forth
opportunities as well as challenges. Also, given the fact that 75 per cent of the financial sector
assets come from banking services, this industry plays a pivotal role in governing the economy.
The PSBs which were the commanding heights in the Indian banking business were shaken out
of their stupor with the entry of the private sector banks in the 1990s. Indian Banks
Association (IBA), the apex body of banks attributes this entry of private sector banks in 1996
to have significantly influenced 'qualitative' and 'quantitative' changes in performance of all
banks in the country. The public sector banks continue to be a dominant part of the banking
system. As on March 31, 2008, the PSBs accounted for 69.9 per cent of the aggregate assets and
72.7 per cent of the aggregate advances of the Scheduled commercial banking system. Gone are
the days when PSBs were synonymous to rising operating costs, mounting NPAs, declining
profits and unfriendly customer service. Today, PSBs have transcended to the world of
competitive banking and institutional reforms. They have taken a new qualitative form resulting
in critical assessment of internal methods and practices, a greater appreciation of the role of
technology for ushering in customer-friendly changes and innovative ways and means of
improving bottom lines. These changes have helped them retain their dominant position and
have made the private and foreign banks more aggressive in their approach.
As M B M Rao, CMD, Canara Bank opines, "Indian banks have emerged stronger in terms of
profitability, asset quality and bottom-line growth. Several balance sheet and profitability
43

indicators of the Indian banking sector have inched closer to the global benchmarks. The
adoption of international best practices in crucial areas such as prudential norms, capital
adequacy, banking supervision, data dissemination and corporate governance has together
enhanced the strength and resilience of the Indian banking sector." The overall growth in the
sector has been brought about by deregulation which opened several new opportunities for
banks to increase revenues by diversifying into areas like investment banking, insurance, credit
cards, depository services, mortgage financing, securitization, etc. This has resulted into a
marked improvement in the financial health of commercial banks in terms of capital adequacy,
profitability and asset quality. It has also resulted into greater choices for consumers and an
increased level of sophistication and technology in banks. As banks benchmarked themselves
against global standards, technology was the key and customer service became the buzzword.
Technology changed the face of banking by bringing a customer-centric approach to the
industry. The private sector banks took the initiative in introducing anytime, anywhere banking,
to their customers. ATMs, internet banking, D-MAT, plastic money were the tools that these
banks used to woo the customers. The need to use enabling technology to provide value-for-
money services to the customers, not only helped them reduce operational costs but also helped
them in cross-selling, which was an imperative need of the hour. Thus began the thrust on retail
banking and in just four years of focussing on this retail banking approach, the four main
private sector banks HDFC, UTI, IDBI and ICICI mopped up over Rs 67, 688 crore of deposits
which meant six per cent share of the total deposits. According to projections for 2010 made by
IBA, the total deposits of banks in India are expected to increase to Rs. 3,500,000 crore. The
implementation of the Basel II accord is expected to strengthen the financial health of banks by
adopting globally accepted norms for capital adequacy. Also with the roadmap given to foreign
banks and other globally competitive strategies, it will not be a surprise if the Indian banking
sector overshoots these projections!
National Electronic Fund Transfer
The NEFT was launched by the RBI in November 2005 as a more secure, nationwide retail
electronic payment system to facilitate funds transfer by the bank customers, between the
networked bank branches in the country. It has, however, been observed that the public sector
banks are not the most active users of this product and the majority of NEFT outward
44

transactions are originated by a few new-generation private sector banks and foreign banks. For
instance, in June 2008, while these banks, as a segment, accounted for a little over 43 per cent
each of the aggregate volume of outward and inward NEFT transactions, the share of public
sector banks in total outward NEFT transactions was rather low at a little over 12 per cent, of
which half the volume was the contribution of the State Bank of India. The RBI has been
pursuing the matter with the PSBs for increasing their participation in the NEFT system in
terms of the number of NEFT-enabled branches and the number of NEFT transactions
originated by them. In order to popularize the e-payments in the country, the RBI, on its part,
has waived the service charges to be levied on the member banks, till March 31, 2009, in
respect of the RTGS and NEFT transactions. The RBI also provides, free of charge, intra-day
liquidity to the banks for the RTGS transactions. The service charges to be levied by banks from
their customers for RTGS & NEFT have, however, been deregulated and left to discretion of the
individual bank. It has been our experience that while some of the banks have rationalized their
service charges and a few have made it even cost-free to the customers, there are also certain
banks that have fixed multiples slabs or unreasonably high service charges, at times linked to
the amount of the transaction, for providing these services to their customers even though the
RBI provides these services to the banks free of charge.
ATM Networks
The National Financial Switch (NFS) network started its operations on August 27, 2004 and is
owned and operated by Institute for Development and Research in Banking Technology
(IDRBT), Hyderabad. NFS is one of the several shared ATM networks which interconnect the
banks ATM switches together and thus, enable inter-operability of the ATM cards issued by any
bank across the entire network. While there are a few other ATM networks also functioning in
the country, the NFS has emerged to be the largest one, with a network of 28,773 ATMs of 31
banks, including 16 public sector banks. The primary objective of any ATM network, like the
NFS, is to make the ATM deployment more economical and viable for banks by pooling their
respective ATM resources. The main advantage of an ATM network is that it obviates the need
for having bank-specific multiple ATM installations in the same geographical area, thereby
reducing the entailed costs for the banks but without compromising on the reach of the banks to
their customers. From the customers perspective, the ATM card of any bank can be used in any
45

ATM which enables more convenient and wider ATM access to the bank customers of varied
banks in different geographical areas.
As regards the charges for use of the ATMs connected through any of the ATM networks in the
country, while the balance enquiry by the customers is free of any charges, the cash withdrawal
from such ATMs, which currently attracts a nominal charge, would also become cost free for the
customers from April 1, 2009,. Thus, the networking of the ATMs across the country, by
leveraging the technology, is indeed a very customer-friendly development.
At end-June 2008, the number of ATMs in the country stood at 36,314 of which the number of
ATMs deployed by the PSBs, new-private-sector, old-private-sector and foreign banks was
22,525, 10,552, 2,189 and 1048 ATMs, respectively. At the system level, the banks had planned
the installation of another 10,560 ATMs during 2008-09. During the quarter ended June 2008,
the daily average number of hits on the ATMs of the PSBs aggregated 31,31,431, with the daily
average amount of transactions at Rs. 759.81 crore as against the corresponding figure of
14,91,399 and over Rs. 385 crore for the (old and new) private sector banks, of which the new
private sector banks accounted for a loins share at 12,84, 071 hits and around Rs. 329 crore in
the value of daily transactions.
Credit Cards
There has been phenomenal increase in the number of credit cards issued by the banks in India
during the last few years and a majority of the PSBs has been in the credit card business since
long. The number of credit cards outstanding at the end of June 2008 was 27.02 million as
against 24.39 million in June 2007. Of these, the number of credit cards issued by public sector
banks was 3.8 million, of which 3.9 million cards were issued by the SBI Cards a joint venture
of GE Money and SBI. The usage of credit cards has also recorded an increase of 10.73 per cent
during the year this period, which is mainly at the Point of Sale (POS) terminals. In June 2008,
the number of transactions by credit cards at POS terminals was 20.6 million as against 17.2
million transactions in June 2007, reflecting an increase of almost 20 per cent during the year.
The amount involved in these transactions recorded a growth of 25.6 per cent during the year
ended June 2008 with the aggregate value of such transactions at Rs. 5261.63 crore. While the
increasing usage of the credit cards is a welcome development in as much as it reduces reliance
46

on currency for settlement of transactions, it also entails certain additional elements of
operational risk and can be a potential source of customer complaints. The RBI, based on the
complaints received from the credit card holders, had undertaken a study of the credit card
operations of the banks. The RBI has since advised the banks in July 2008, the recommendations
emerging from the study, for implementation. These recommendations are fairly wide ranging
and encompass several issues in the areas of card issuance, card statements, interest and other
chares on the cards, using the services of direct selling / marketing agents, redressal of
customers grievances, reporting of default information of the card holder to the CIBIL, etc. We
would urge the banks to put in place necessary mechanism to ensure meticulous compliance with
these instructions of the RBI so as to minimize, if not eliminate, the risks and customer
complaints in the area of credit card operations.
Satellite banking
We might be aware, having regard to much greater reliability of a satellite-based communication
link for interconnecting the branches of the banks, particularly in the hilly areas and difficult
terrain where terrestrial communication link is difficult to provide, the RBI had constituted a
Technical Group to examine the proposal for providing satellite connectivity to the bank
branches in such areas. The objective is to enable greater penetration of the electronic payment
products in the hinterland areas also, by facilitating the integration of the rural and remote
branches with the core banking solution platform of the banks and help them providing efficient
banking services to their customers. Under the proposal, the RBI would be bearing a part of the
leased rentals for the satellite connectivity, provided the banks use it for connecting their
branches in the North Eastern States and in the under-banked districts in the rest of the country.
Thus, the RBI would be providing an incentive to the banks for adopting the satellite
communication technology for networking their branches in the remote areas.




47

Challenges facing Banking Industry in India
The banking industry in India is undergoing a major transformation due to changes in economic
conditions and continuous deregulation. These multiple changes happening one after other has a
ripple effect on a bank (Refer fig. 2.1) trying to graduate from completely regulated sellers
market to completed deregulated customers market.



Deregulation:
This continuous deregulation has made the Banking market extremely competitive with greater
autonomy, operational flexibility, and decontrolled interest rate and liberalized norms for foreign
exchange. The deregulation of the industry coupled with decontrol in interest rates has led to
entry of a number of players in the banking industry. At the same time reduced corporate credit
48

off take thanks to sluggish economy has resulted in large number of competitors battling for the
same pie.
New rules:
As a result, the market place has been redefined with new rules of the game. Banks are
transforming to universal banking, adding new channels with lucrative pricing and freebees to
offer. Natural fall out of this has led to a series of innovative product offerings catering to
various customer segments, specifically retail credit.
Efficiency:
This in turn has made it necessary to look for efficiencies in the business. Banks need to access
low cost funds and simultaneously improve the efficiency. The banks are facing pricing pressure,
squeeze on spread and have to give thrust on retail assets.
Diffused Customer loyalty:
This will definitely impact Customer preferences, as they are bound to react to the value added
offerings. Customers have become demanding and the loyalties are diffused. There are multiple
choices; the wallet share is reduced per bank with demand on flexibility and customization.
Given the relatively low switching costs; customer retention calls for customized service and
hassle free, flawless service delivery.
Misaligned mindset:
These changes are creating challenges, as employees are made to adapt to changing conditions.
There is resistance to change from employees and the Seller market mindset is yet to be changed
coupled with Fear of uncertainty and Control orientation. Acceptance of technology is slowly
creeping in but the utilization is not maximized.
Competency Gap:
Placing the right skill at the right place will determine success. The competency gap needs to be
addressed simultaneously otherwise there will be missed opportunities. The focus of people will
49

be on doing work but not providing solutions, on escalating problems rather than solving them
and on disposing customers instead of using the opportunity to cross sell.
Strategic options with banks to cope with the challenges
Leading players in the industry have embarked on a series of strategic and tactical initiatives to
sustain leadership. The major initiatives include:
Investing in state of the art technology as the back bone of to ensure reliable service
delivery.
Leveraging the branch network and sales structure to mobilize low cost current and
savings deposits.
Making aggressive forays in the retail advances segment of home and personal loans.
Implementing organization wide initiatives involving people, process and technology to
reduce the fixed costs and the cost per transaction.
Focusing on fee based income to compensate for squeezed spread, (e.g. CMS, trade
services).
Innovating Products to capture customer mind share to begin with and later the wallet
share.
Improving the asset quality as per Basel II norms.







50

Basel Norm
Introduction
The core business of banks is to take deposit from public and lend to individuals, industries,
business etc. These loans carry risk of becoming bad debt (debtor is unable to return its debt) and
hence non-performing. Since the major deposit of bank comes from public, the government and
regulatory authorities are worried that the bank might be tempted to operate on thin capital and
expose the depositors to undue credit risk. Therefore, banks all over world are required to keep
a specified percentage of their loan portfolio as capital and if some loan goes bad, the loss is
borne by the capital and not by depositors. Banks hence are required to maintain a capital
adequacy ratio specified by the regulatory bodies.
Basel norm is a framework of capital adequacy for banks. These norms set the guidelines to
estimate the amount of capital assets of specified kind should bank hold to absorb losses. The
assessment of such losses that bank can incur decides the proportion of liquid asset banks must
have at hand to meet those losses in case they are incurred. The loss can be based on the risk
exposure i.e. credit, operational or market risks etc. The higher the risk of loss associated with
an investment, the more of liquid asset will have to be maintained. A 100 percent risk-weight
loss implies that the whole of the investment can be lost under certain conditions and a zero
percent risk-weight indicates that the concerned asset is risk-free. The Basel II norms is
improvement over the earlier Basel I norms.
For banks which are active globally, it is imperative to bolster their capital in accordance with
the supervisory standards and guidelines formulated by the Basel Committee. The committee
which was constituted by Central Bank Governors of a Group of 10 countries in 1974 under the
aegis of the Bank of International Settlements (BIS) has, over the years set out standards for
capital measurement. The BIS is regarded as the bank for central banks and is based in Basel in
Switzerland. Basel II norms require banks to set aside higher capital for more risky assets.

51

Tier 1 Capital
It is a measure of capital adequacy of a bank, and is the ratio of a bank's core equity capital to
its total risk-weighted assets. Risk weighted assets is the total of all assets held by the bank
which are weighted for credit risk according to a formula determined by the Regulator (usually
the country's Central Bank). Most Central Banks follow the BIS - Bank of International
Settlements guidelines in setting asset risk weights. Assets like cash and coins usually have zero
risk weights, while unsecured loans might have a risk weight of 100%.Both tier 1 and tier 2
capital were first defined in the Basel I capital accord. The new, Basel II, accord has not changed
the definitions in any substantial way.
Tier 2 capital
It is a measure of a bank's financial strength with regard to the second most reliable form of
financial capital, from a regulator's point of view. The forms of banking capital were largely
standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and
left untouched by the Basel II accord. Tier is considered the more reliable form of capital.
National regulators of most countries around the world have implemented these standards in
local legislation. This includes the Board of Governors of the Federal Reserve System of the
United States (FRB).
Capital adequacy ratio is defined as
OR 8%
Basel committee:
The Basel Committee on Banking Supervision provides a forum for regular cooperation on
banking supervisory matters. Its objective is to enhance understanding of key supervisory issues
and improve the quality of banking supervision worldwide. It seeks to do so by exchanging
information on national supervisory issues, approaches and techniques, with a view to promoting
common understanding. The Committee's Secretariat is located at the Bank for International
Settlements (BIS) in Basel, Switzerland.
52

Need for such norms:
The first accord by the name Basel Accord I. was established in 1988 and was implemented by
1992. It was the very first attempt to introduce the concept of minimum standards of capital
adequacy. Then the second accord by the name Basel Accord II was established in 1999 with a
final directive in 2003 for implementation by 2006 as Basel II Norms. Unfortunately, India could
not fully implement this but, is now gearing up under the guidance from the Reserve Bank of
India to implement it from 1 April, 2009.Basel II Norms have been introduced to overcome the
drawbacks of Basel I Accord. For Indian Banks, it is the need of the hour to buckle-up and
practice banking business at par with global standards and make the banking system in India
more reliable, transparent and safe. These Norms are necessary since India is and will witness
increased capital flows from foreign countries and there is increasing cross-border economic &
financial transactions.
The Basel I Accord
Basel Committee on Banking Supervision (BCBS)
On 26th June 1974, a number of banks had released Deutschmarks to Bank Herstatt in Frankfurt
in exchange for dollar payments that were to be delivered in New York. Due to differences in
time zones, there was a lag in dollar payments to counter-party banks during which Bank
Herstatt was liquidated by German regulators, i.e. before the dollar payments could be affected.
The Herstatt accident prompted the G-10 countries (the G-10 is today 13 countries: Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland,
United Kingdom and United States) to form, towards the end of 1974, the Basel Committee on
Banking Supervision (BCBS), under the auspices of the Bank for International Settlements
(BIS), comprising of Central Bank Governors from the participating countries.BCBS has been
instrumental in standardizing bank regulations across jurisdictions with special emphasis on
defining the roles of regulators in cross-jurisdictional situations. The committee meets four times
a year. It has around 30 technical working groups and task forces that meet regularly.

53

1988 Basel Accord
In 1988, the Basel Committee published a set of minimal capital requirements for banks,
known as the 1988 Basel Accord. These were enforced by law in the G-10 countries in 1992,
with Japanese banks permitted an extended transition period. The 1988 Basel Accord focused
primarily on credit risk. Bank assets were classified into five risk buckets i.e. grouped under
five categories according to credit risk carrying risk weights of zero, ten, twenty, fifty and one
hundred per cent. Assets were to be classified into one of these risk buckets based on the
parameters of counter-party (sovereign, banks, public sector enterprises or others), collateral (e.g.
mortgages of residential property) and maturity. Generally, government debt was categorized at
zero per cent, bank debt at twenty per cent, and other debt at one hundred per cent. 100%. OBS
exposures such as performance guarantees and letters of credit were brought into the calculation
of risk weighted assets using the mechanism of variable credit conversion factor. Banks were
required to hold capital equal to 8% of the risk weighted value of assets. Since 1988, this
framework has been progressively introduced not only in member countries but also in almost all
other countries having active international banks. The 1988 accord can be summarized in the
following equation:
Total Capital = 0.08 x Risk Weighted Assets (RWA)
The accord provided a detailed definition of capital. Tier 1 or core capital, which includes equity
and disclosed reserves, and Tier 2 or supplementary capital, which could include undisclosed
reserves, asset revaluation reserves, general provisions & loanloss reserves, hybrid (debt/equity)
capital instruments and subordinated debt.
Value at Risk (VAR)
VAR is a method of assessing risk that uses standard statistical techniques and provides users
with a summary measure of market risk. For instance, a bank might say that the daily VAR of its
trading portfolio is rupees 20 million at the 99 per cent confidence level. In simple words, there
is only one chance in 100, under normal market conditions, for a loss greater than rupees 20
million to occur. This single number summarizes the bank's exposure to market risk as well as
the probability (one per cent, in this case) of it being exceeded. Shareholders and managers can
then decide whether they feel comfortable at this level of risk. If not, the process that led to the
54

computation of VAR can be used to decide where to trim risk. Now the definition; `VAR
summarizes the predicted maximum loss (or worst loss) over a target horizon within a given
confidence interval. Target horizon means the period till which the portfolio is held. Ideally, the
holding period should correspond to the longest period needed for orderly (as opposed to a fire
sale) portfolio liquidation. Without going into the related math, it should be mentioned here that
there exist three methods of computing VAR, viz. Delta-Normal, Historical Simulation and
Monte Carlo Simulation, the last one being the most computation intensive and predictably the
most sophisticated one.
In 1996, BCBS published an amendment to the 1988 Basel Accord to provide an explicit capital
cushion for the price risks to which banks are exposed, particularly those arising from their
trading activities. This amendment was brought into effect in 1998.
Salient Features
Allows banks to use proprietary in-house models for measuring market risks.
Banks using proprietary models must compute VAR daily, using a 99th percentile, one-tailed
confidence interval with a time horizon of ten trading days using a historical observation period
of at least one year.
The capital charge for a bank that uses a proprietary model will be the higher of the previous
day's VAR and three times the average of the daily VAR of the preceding sixty business days.
Use of `back-testing (ex-post comparisons between model results and actual performance) to
arrive at the `plus factor that is added to the multiplication factor of three.
Allows banks to issue short-term subordinated debt subject to a lock-in clause (Tier 3 capital)
to meet a part of their market risks.
Alternate standardized approach using the `building block approach where general market risk
and specific security risk are calculated separately and added up.


55

Evolution of Basel Committee Initiatives

The Basel I Accord and the 1996 Amendment thereto have evolved into Basel II, as depicted
in the figure above
The New Accord (Basel II)
Close on the heels of the 1996 amendment to the Basel I accord, in June 1999 BCBS issued a
proposal for a New Capital Adequacy Framework to replace the 1988 Accord.The proposed
capital framework consists of three pillars: minimum capital requirements, which seek to refine
the standardized rules set forth in the 1988 Accord; supervisory review of an institution's internal
assessment process and capital adequacy; and effective use of disclosure to strengthen market
discipline as a complement to supervisory efforts. The accord has been finalized recently on 11
th
May 2004 and the final draft is expected by the end of June 2004. For banks adopting advanced
approaches for measuring credit and operational risk the deadline has been shifted to 2008,
whereas for those opting for basic approaches it is retained at 2006.
The Need for Basel II
The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad
brush structure) for measuring credit risk. For example, all corporations carry the same risk
weight of 100 per cent. It also gave rise to a significant gap between the regulatory measurement
of the risk of a given transaction and its actual economic risk. The most troubling side effect of
the gap between regulatory and actual economic risk has been the distortion of financial
56

decision-making, including large amounts of regulatory arbitrage, or investments made on the
basis of regulatory constraints rather than genuine economic opportunities. The strict rule based
approach of the 1988 accord has also been criticized for its `one size fits all prescription. In
addition, it lacked proper recognition of credit risk mitigants such as credit derivatives,
securitization, and collaterals. The recent cases of frauds, acts of terrorism, hacking, have
brought into focus the operational risk that the banks and financial institutions are exposed to.
The proposed new accord (Basel II) is claimed by BCBS to be `an improved capital adequacy
framework intended to foster a strong emphasis on risk management and to encourage ongoing
improvements in banks risk assessment capabilities. It also seeks to provide a `level playing
field for international competition and attempts to ensure that its implementation maintains the
aggregate regulatory capital requirements as obtaining under the current accord. The new
framework deliberately includes incentives for using more advanced and sophisticated
approaches for risk measurement and attempts to align the regulatory capital with internal risk
measurements of banks subject to supervisory review and market disclosure.
Features of Basel II norms:
Basel II Norms are considered as the reformed & refined form of Basel I Accord. The Basel II
Norms primarily stress on 3 factors, viz. Capital Adequacy, Supervisory Review and Market
discipline. The Basel Committee calls these factors as the Three Pillars to manage risks.

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PILLAR I:
Minimum Capital Requirements
There is a need to look at proposed changes in the measurement of credit risk and operational
risk.

1. Credit Risk
Three alternate approaches for measurement of credit risk have been proposed. These are:
Standardized
Internal Ratings Based (IRB) Foundation
Internal Ratings Based (IRB) Advanced

The standardized approach is similar to the current accord in that banks are required to slot
their credit exposures into supervisory categories based on observable characteristics of the
exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The
standardized approach establishes fixed risk weights corresponding to each supervisory category
and makes use of external credit assessments to enhance risk sensitivity compared to the
current accord. The risk weights for sovereign, inter-bank, and corporate exposures are
differentiated based on external credit assessments. An important innovation of the standardized
approach is the requirement that loans considered `past due be risk weighted at 150 per cent
58

unless, a threshold amount of specific provisions has already been set aside by the bank against
that loan. Credit risk mitigants (collaterals, guarantees, and credit derivatives) can be used by
banks under this approach for capital reduction based on the market risk of the collateral
instrument or the threshold external credit rating of recognized guarantors.
Reduced risk weights for retail exposures, small and medium size enterprises (SME) category
and residential mortgages have been proposed. The approach draws a number of distinctions
between exposures and transactions in an effort to improve the risk sensitivity of the resulting
capital ratios. The IRB approach uses banks internal assessments of key risk drivers as primary
inputs to the capital calculation. The risk weights and resultant capital charges are determined
through the combination of quantitative inputs provided by banks and formulae specified by the
Committee. The IRB calculation of risk weighted assets for exposures to sovereigns, banks, or
corporate entities relies on the following four parameters:
Probability of default (PD), which measures the likelihood that the borrower will
default over a given time horizon.
Loss given default (LGD), which measures the proportion of the exposure that will be
lost if a default occurs.
Exposure at default (EAD), which for loan commitment measures the amount of the
facility that is likely to be drawn in the event of a default.
Maturity (M), which measures the remaining economic maturity of the exposure.


2. Operational Risk
Within the Basel II framework, operational risk is defined as the risk of losses resulting from
inadequate or failed internal processes, people and systems, or external events. Operational risk
identification and measurement is still in an evolutionary stage as compared to the maturity that
market and credit risk measurements have achieved.
As in credit risk, three alternate approaches are prescribed:
Basic Indicator
Standardized
Advanced Measurement (AMA)
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PILLAR 2:
Supervisory Review Process
Pillar 2 introduces two critical risk management concepts: the use of economic capital, and the
enhancement of corporate governance, encapsulated in the following four principles:
Principle 1:
Banks should have a process for assessing their overall capital adequacy in relation to their
risk profile and a strategy for maintaining their capital levels.
The key elements of this rigorous process are:
Board and senior management attention;
Sound capital assessment;
Comprehensive assessment of risks;
Monitoring and reporting; and
Internal control review.
Principle 2:
Supervisors should review and evaluate banks internal capital adequacy assessments and
strategies, as well as their ability to monitor and ensure their compliance with regulatory
capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied
with the result of this process.
This could be achieved through:
On-site examinations or inspections;
Off-site review;
Discussions with bank management;
Review of work done by external auditors; and
Periodic reporting.

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Principle 3:
Supervisors should expect banks to operate above the minimum regulatory capital ratios and
should have the ability to require banks to hold capital in excess of the minimum.
Principle 4:
Supervisors should seek to intervene at an early stage to prevent capital from falling below
the minimum levels required to support the risk characteristics of a particular bank and
should require rapid remedial action if capital is not maintained or restored.
Prescriptions under Pillar 2 seek to address the residual risks not adequately covered under Pillar
1, such as concentration risk, interest rate risk in banking book, business risk and strategic risk.
`Stress testing is recommended to capture event risk. Pillar 2 also seeks to ensure that internal
risk management process in the banks is robust enough. The combination of Pillar 1 and Pillar 2
attempt to align regulatory capital with economic capital.
PILLAR 3:
Market Discipline
The focus of Pillar 3 on market discipline is designed to complement the minimum capital
requirements (Pillar 1) and the supervisory review process (Pillar 2). With this, the Basel
Committee seeks to enable market participants to assess key information about a banks risk
profile and level of capitalizationthereby encouraging market discipline through increased
disclosure. Public disclosure assumes greater importance in helping banks and supervisors to
manage risk and improve stability under the new provisions which place reliance on internal
methodologies providing banks with greater discretion in determining their capital needs.
There has been some confusion on the extent, medium, confidentiality and materiality of such
disclosures. It has been agreed that such disclosures will depend on the legal authority and
accounting standards existing in each country. Efforts are in progress to harmonise these
disclosures with International Financial Reporting Standards (IFRS) Board Standards
(International Accounting Standards 30 & 32).

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Scope of BASEL II
Following are the parties which will be affected by the BASEL II norms:
All banks in the 110 countries that have signed Basel II will be affected.
o Basel II will directly cover bank-owned or controlled insurance entities. Moreover,
insurance companies that own or control banks/non-insurance financial services functions
will be covered by the new rules.
o Though the primary focus is banks that are active internationally, the G-20 central banks
and the regulatory authorities of most of the countries that are signatories to Basel II are
applying the policies to all the financial service institutions in their specific jurisdiction
and are expecting the other countries to follow suit.
o It should be noted that regulatory jurisdictions such as the United States, United
Kingdom, and the rest of the European Union are moving quite aggressively to use the
Basel II framework in their areas to harmonize the capital adequacy and regulatory
oversight rules and regulations across all sectors of the financial industry. Similar efforts
are also under way in Australia, Singapore, India, and Hong Kong. Many emerging
market countries that are signatories to Basel II are also in the process of implementing
this framework, using this as an opportunity to re-structure their financial industry
Implementation of BASEL II globally and locally
In 1998, the BASEL committee was convinced that BASEL I norms werent fool proof and it
could not be patched up by a few modifications. In fact, the need of the hour (and the future) was
a complete overhaul of the capital accord. Thus after 10 years we now have the new
recommended capital accord which is more popularly known as BASEL II. It has been updated
since then to incorporate various improvements.
Globally, BASEL II is in implementation since 2006. In India, the foreign banks and Indian
banks that have overseas operations are required to switch over to BASEL II from 31
st
March,
2008 while the other banks can switch over from 31
st
March, 2009.
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In Switzerland, the norms were implemented from 2006. Way back in 2005, the US had started
out with some apprehension adopting the new capital accord. However, right at the outset the US
had prescribed the banks with foreign exposure above a minimum threshold limit to adopt
advance measurements for credit and operational risks.
The impact of Basel II
To further evaluate the effects of the Basel II Framework on capital levels beyond the QIS 3
study in 2002, QIS 4 was completed on a limited basis in 2004 in Germany, the US and South
Africa, in addition to a field test in Japan in 2005. Following issuance of the trading book rules
which the Basel Committee developed together with the International Organization of Securities
Commissions and the Committees guidance on economic recession loss-given-default (LGD) in
2005, a global fifth Quantitative Impact Study (QIS 5) was undertaken in 31 countries. All G10
(a subset of G13) countries (except the US) and 19 non-G10 countries participated in the
exercise. Sample of participating banks The QIS 5 effort encompasses results from 32 countries.
The data are received from 82 G10 Group 1 banks, 146 G10 Group 2 banks, and 54 banks from
other countries. As in QIS 3, Group 1 banks are those that meet the following three criteria: The
bank has Tier 1 capital in excess of 3bn; the bank is diversified; and the bank is internationally
active. In QIS 5, the Committee considered three different country groupings: G10, which
includes the 13 Basel Committee member countries. European countries, which comprises the
Committee of European Banking Supervisors (CEBS). This group is referred to as the CEBS
group. Other non-G10 countries encompasses all non-G10 countries that are not part of the
CEBS group.

Impact on total capital adequacy for banks
No immediate fall in capital levels.
Early views on Basel II jumped on the prospect of significant changes in the capital adequacy of
banks, particularly the potential for a large decline in RWAs for credit risk. Even with the
inclusion of a capital requirement for operational risk, this did not seem to offset the reduction in
credit risk. In the years since the first agreed draft of Basel II in June 2004 it has transpired that it
would not be that simple. A number of factors have contributed to this, such as: Closer reading
of the implications of demonstrating sound capital assessment. Pillar 2, particularly with
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Regulatory statements pronouncing that existing capitalization in the banking sector is about
right. The magnitude of work required by banks across their entire financial, risk, technology and
governance frameworks to truly meet not only the quantitative results, but also the qualitative
standards. The competing resource requirements to meet not only Basel II, but to apply
International Accounting Standards (IAS), not to mention the challenge of aligning the
accounting changes with Basel II. Further development of regulatory standards and the level of
scrutiny of internal models for validation and use across the bank. Potential for some capital
relief over the medium term. Despite these challenges, many banks have (or should have)
considered modeling the potential capital adequacy outcome under various scenarios and
developing longer term strategies regarding their approach to investing in risk management
capabilities and overall capital management.

Management of Pillar 2 risks
More than a risk management tool
Leading banks have recognized and invested in methods and processes to better align their risk
and finance management infrastructures to measure, manage and understand risk-adjusted
performance. The effective identification of value creation in terms of capital optimization and
pricing have generally developed on the platform of economic capital and capital allocation. This
capability is viewed as more than a risk management tool, but as providing a strategic
competitive advantage. Practices and approaches vary, but are now recognized as a standard
requirement in todays banking environment. This is reflected in the requirements in Pillar 2:

Challenges in implementing Basel II

The most important challenge in adopting BASEL II successfully is in the form of maintaining
a sea of data. The second is to build the kind of infrastructure that is required to store, transfer
and retrieve data. Not only that the systems must now be guarded, as much as possible, against
frauds, thefts and loss. The systems should have the inbuilt ability to perform a variety of
functions.
With many public sector banks operating on a wide scale in remotest village, obtaining that kind
of infrastructural command will be a big problem.
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The stringent second and third pillar requirement puts a great deal of demand on the skills and
talents of the top level management. The new capital accord will require realignment of
strategies to minimize the risks and optimize capital. The advanced methodologies will require
experience and superlative training. Procuring that kind of manpower will be an issue in the
first couple of years.
Some models of measuring risks require a thorough understanding and an accurate
estimation. For example, the long time horizons required in case of VaR model. Getting
accuracy in such cases is difficult in the initial years.
Also, banks globally had started implementing BASEL II since 2006. The apex institutions
there have also allowed many banks to use internal ratings for credit risk and advanced methods
for operational risk. They have a natural advantage in the understanding of the system over
the Indian banks and hence over a period of time they will gain a competitive advantage
over domestic banks.
In most of the cases, the banks will need to maintain more capital than they were
maintaining under BASEL I. This is likely to happen because of the additional capital that will
be needed to provide for operational risk. This will cause an additional burden on the smaller
banks. Thus, BASEL II might disadvantage the economically marginalized by restricting their
access to credit or by making it more expensive.
Another challenge that needs to be acknowledged is that BASEL II will lead to more pronounced
business cycles. In the sense that most credit risk models take a period of 1 year into account.
Thus, during a downturn the banks will have to reduce lending as the models will forecast
increased losses.
The standardized approach requires the ratings assigned by the eligible external agencies.
However, the rating penetration in India is not too deep. Also, rating here is only issue based and
not issuer based and it provides a lagging perspective rather than a leading perspective.
Implementing the pillar 2 requirement of ICAAP will be another hurdle for the Indian banks at it
requires comprehensive assessment of risk modeling and management and have to compute the
risks other than those mentioned in pillar 1.
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Investment in risk management and Basel II framework is accelerating
This recognition is acknowledged by most regulators and will be a large effort for them to apply
the Basel II framework and for the banks to comply with it. The key common risk management
challenges across most countries are in the areas of: Skilled risk management resources. Data
availability. Modeling capability. Both Hong Kong and Singapore are quite advanced in their
preparations, while institutions in other Asian countries are rapidly addressing their
implementation programs.

Most of the Basel Committees objectives are likely to be met
The implementation of Basel II will drive significant improvement in risk management practices
across the banking industry. The degree of cultural, behavioral and process change is not to be
underestimated and will cause moments of angst amongst all stakeholders. However, the train is
on the tracks and will drive the banking environment for the next decade (or until Basel III
comes along). This will see: Pressure to improve risk management from supervisors and the
market. Basel II being an ongoing process and capability, not an event or number. The evolution
of a common language of risk. Incentives to develop and integrate economic capital models.
Acceptance, management and measurement of credit risk becoming more scientific and
disciplined.
The culmination of the Basel II initiative will be a large step to achieving (in the words of the
Basel Committee on Banking Supervision International Convergence of Capital Measurement
and Capital Standards June 2006, paragraph 4): 4. The fundamental objective of the
Committees work to revise the 1988 Accord has been to develop a framework that would
further strengthen the soundness and stability of the international banking system while
maintaining sufficient consistency that capital adequacy regulation will not be a significant
source of competitive inequality among internationally active banks. the revised framework
will promote the adoption management practices by the banking industry. Of stronger risk
Banks and other interested partieshave expressed support for improving capital regulation to
take into account changes in banking and risk management practices while at the same time
preserving the benefits of a framework that can be applied as uniformly as possible at the
national level.

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Basel Norm in Indian Banking System:

Basel I in India

Basel I was implemented in India by 1996 (Process got started in 1992-93 and was spread over
3/4 years). However, capital charges for market risk under Basel I got implemented in June 2004
and subsequently based upon recommendation of Steering committee, the Reserve Bank of India
(RBI) issued draft guidelines for Basel II in 2005. Banks in India are statutorily required to
maintain capital for credit risk and market risk. In India, Capital adequacy ratio, termed as
Capital to risk assets ratio (CRAR) is set at 9%. However, banks are not allowed, at present, to
use Tier III capital towards market risk capital charge.
Three major inadequacy of Basel I norms were
1. Non-differentiation: The norms treated all borrowers alike.
2. No weightage was given to availability of security for credit facility.
3. It treated loans of varying maturity in the same manner.
Regarding the first issue, in Basel I, banks were required to keep 8 percent of loan as capital,
whether the borrower is a first class blue chip company, with little or no risk, or it is a third rate
company with poor track record. Basel II introduced the concept of 5 different risk weights,
20%, 30%, 50%, 100% and 150%. For the highest rated borrower, banks need to keep only 20%
of 8 percent or 1.6 percent (8x 20%) of the credit exposure as capital. The RBI has retained the
higher base level of 9 percent against world level of 8%.
For the second issue, value of security has been given due consideration while computing the
capital charge for a loan.
Taking the last point, the Basel I rule prescribed the same amount of capital whether the loan
was for a short period or for a very long period. As the period gets longer the risk associated with
the loan increases. Basel II has made some distinction between short and long-term loans given
by one bank to another.

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Basel II in India

Reserve Bank of India circular on Prudential guidelines on capital adequacy Implementation
of new capital adequacy framework. The banks are required to adopt new Basel II norms by
March 31, 2007. Basel II compliance is expected to increase the capital requirement as it
captures operational risk. The cushion available in the system, which at present has a Capital
to Risk Assets Ratio (CRAR) of over 12 per cent, provides for some comfort (as a survey made
by FICCI shows). However, keeping in mind a sustainable requirement of capital, the Reserve
Bank has, for its part, issued policy guidelines enabling issuance of several instruments by the
banks innovative perpetual debt instruments, perpetual non-cumulative preference shares,
redeemable cumulative preference shares and hybrid debt instrument.

Basel II: Implementation of the New Capital Adequacy Framework by Banks
in India:
Salient Features
Banks in India shall adopt the Standardized Approach for credit risk, and the Basic Indicator
Approach for operational risk for computing their capital requirements under the Revised
Framework. Banks shall continue to apply the Standardized Duration Approach for computing
capital requirement for market risk.
Foreign banks operating in India and Indian banks having operational presence outside India
should adopt the Revised Framework with effect from March 31, 2008. All other commercial
banks (excluding Local Area Banks and Regional Rural Banks) are encouraged to migrate to the
Revised Framework in alignment with them, but in any case not later than March 31, 2009.
Banks are required to maintain a minimum capital to risk weighted assets ratio (CRAR) of 9
per cent on an ongoing basis. However, taking into account the relevant risk factor and internal
capital adequacy assessments of each bank, the Reserve Bank may prescribe a higher level of
minimum capital ratio to ensure that the capital held by a bank is commensurate with its overall
risk profile.
Banks are required to maintain, at both solo and consolidated level, a minimum Tier I ratio of
at least 6 per cent. Banks below this level must achieve this ratio on or before March 31, 2010.
The minimum capital maintained by banks on implementation of Basel II norms shall be
subject to a prudential floor computed with reference to the requirement as per Basel I
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framework for credit and market risks. The floor has been fixed at 100 per cent, 90 per cent and
80 per cent for the position as at end-March for the first three years of implementation of the
Revised Framework.
Banks may use the credit ratings awarded by the following four credit rating agencies for
assigning risk weights for credit risk for capital adequacy purposes: Credit Analysis and
Research Ltd., CRISIL Ltd., Fitch India, and ICRA Ltd. Banks are also allowed to use the credit
ratings of following three international rating agencies: Fitch, Moodys and Standard & Poors.
Claims on domestic sovereigns (Central and State Governments) will attract a zero risk weight
while those guaranteed by State Governments will attract 20 per cent risk weight.
Risk weights for claims on banks will be linked to the capital adequacy position of the counter
party bank. Scheduled and other banks will receive a differential treatment.
Claims on corporate will be risk weighted as per the ratings awarded by the chosen rating
agencies. Unrated claims on corporate will attract a risk weight of 100 per cent. However,
unrated claims above Rs.50 crore sanctioned/renewed on or after April 1, 2008 will attract a
higher risk weight of 150 per cent; this threshold will be lowered to Rs.10 crore with effect from
April 1, 2009.
Claims eligible for inclusion as regulatory retail portfolio, specified claims secured by
mortgage of residential property, loans and advances to banks own staff meeting the specified
conditions, and consumption loans up to Rs.1 lakh against gold and silver ornaments shall attract
a preferential risk weight ranging between 20 per cent and 75 per cent.
Claims in respect of a few specified categories such as venture capital funds, commercial real
estate, consumer credit including personal loans and credit card receivables, capital market
exposures, and claims on non-deposit taking systemically important NBFCs will attract risk
weights of 125 per cent or 150 per cent.
A portion of unutilized limits will attract capital charge.
A set of collaterals has been specified which eligible for asset is netting. That is, reduction in
capital adequacy requirements will be available to the extent of such collateral held.
Where the benefit of such collateral is taken for asset netting, the value of the collaterals will be
subject a "Haircut" - that is the market value will be reduced by a certain percentage given by
RBI.
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If the exposure is in one currency and the collateral is in another currency, the amount of the
exposure deemed to be protected will be reduced by the application of a haircut - HFx. That is,
the collateral availability will be reduced to provide for currency fluctuations.
If the residual maturity of collateral is less than that of the underlying exposure, then the
collateral cannot be recognized in full and has to be calculated pro-rata to provide for the
maturity mismatch.
Capital requirements for operational risk under the Basic Indicator Approach will be the
average of a fixed percentage (now 15%) of positive annual gross income of the previous three
completed financial years.
A set of disclosure requirements has been prescribed to encourage market discipline.
Banks are required to obtain prior approval of RBI to migrate to the advanced approaches such
as the Internal Rating Based Approach for credit risk and the Standardized Approach or the
Advanced Measurement Approach for operational risk for computing capital requirements. The
prerequisites and procedure for approaching RBI for seeking such approval will be issued in due
course.

Implementation of Basel II: present status

o Basel II Framework offers a new set of international standards for establishing minimum
capital requirements for the banking organizations.
o The Pillar 1 stipulates the minimum capital ratio.
o The Pillar 2 of the framework deals with the Supervisory Review Process.
o The Pillar 3 of the framework, Market Discipline, focuses on the effective public
disclosures to be made by the banks.
o Foreign banks operating in India and Indian banks having operational presence outside
India should adopt the Revised Framework with effect from March 31, 2008.
o All other commercial banks (excluding Local Area Banks and Regional Rural Banks) are
encouraged to migrate to the Revised Framework in alignment with them, but in any case
not later than March 31, 2009.


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Indian Banking SystemGearing up for Basel II
The adequate capital backup, to take care of unexpected losses, has become the real license to
conduct and expand banking business, especially in the case of asset portfolio. The Indian
banking system is better prepared to adopt Basel II than it was for Basel I. Nevertheless, the task
is daunting enough, requiring more rigor and improvement in risk management systems,
especially credit risk measurement and related database. The past trends indicate that to maintain
the present 12% level of Capital to Risk Weighted Assets Ratio), even in March 2007, banks in
India may fall short of capital by Rs. 30,000-Rs. 57,000 cr. Owing to an estimated increase of
risk weighted assets by 15-30%, mainly on account of operational and market risk (if not credit
risk) during Basel II era, nationalized banks and private sector banks seem to be more vulnerable
when compared to the State Bank group and foreign banks in accomplishing such task. The size
of bank being a helpful factor to improve the risk-bearing capacity, consolidation through orderly
mergers and acquisition may be necessary. Asset expansion through proper risk management
culture is another important strategic dimension in the Basel II context with matching
supervision, audit and vigilance systems, which should encourage capturing business rather than
driving it away. Degovernmentalization of public sector banks, through managerial autonomy,
will ensure prompt organizational responses to the fast changing market developments. Draft
guidelines issued by RBI in February 2005 on Basel II implementation clearly indicate a phased
approach, without putting undue pressure on the banking system and, at the same time, aiming to
reach international standards and best practices. Basel II transition should further strengthen the
banks to play a crucial role in ensuring that the fruits of economic reforms, especially the
financial sector reforms, are in the reach of the vast and vulnerable sections of the society.
Basel II: Some issues, some challenges

Scholars have drawn attention to certain shortcomings of the original Basel II guidelines, on the
basis of which individual countries are expected to build their regulatory guidelines. In
particular, many scholars have pointed out that linking credit rating to regulatory capital
standards may have severe macro-economic implications. As the sovereign ratings of developing
and emerging countries are not as high as the industrialized and the high income countries, this
will have an unfavorable effect on the credit flows to developing and emerging economies.
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Empirical studies have pointed out that Basel II may significantly overestimate the risk of
international lending to developing economies.
Further, credit ratings are found to be pro-cyclical (Ferri et al. 1999, Montfort and Mulder
2000). Credit rating agencies upgrade sovereigns in times of sound market conditions and
downgrade in turbulent times. This can potentially add to the dynamics of emerging market
crisis. Bank and corporate ratings in emerging countries are linked to their sovereign ratings. In
times of crisis, when the need for credit may be imperative, credit flow may diminish due to
downgrading of the sovereign (and therefore the bank and corporate) ratings by external rating
agencies, leading to banking crisis, in addition to the currency/balance of payments crisis, what
Kaminsky and Reinhart (1999) call twin crises. This may have severe impact on the macro-
economic stability. For example, Ferri et al. (2000) show that during the East Asian currency
crisis of 1997-98, following Moodys down gradation of sovereign ratings for Indonesia, Korea
and Thailand, the corporate ratings were also downgraded sharply in these countries, leading to a
sharp fall in the international capital flows in the region. Interestingly, even when the sovereign
ratings of Korea and Thailand were upgraded in 1999 following the macro-economic recovery,
corporate ratings continued to remain speculative grade.
Further, the study also found that in the short term, the ratings of non-high income countries
banks are more sensitive to changes in their sovereign ratings in a noticeably asymmetric
manner, i.e. it is more sensitive for sovereign downgrading than sovereign upgrading. Thus,
incorporation of external credit ratings into regulatory capital requirement may lead to serious
macro-economic instability. While these concerns remain for the Indian economy in general,
several issues specific to Indias banking system also arise in the wake of the new regime. In this
section, we discuss the issues specific to the banking system of India.

RBI risk-weighing scheme

A look at the RBIs scheme of risk weighing reveals certain shortcomings. First, RBIs scheme
provides much less risk weights to exposures to scheduled commercial banks than exposures to
other banks/financial institutions. To be more precise, exposure to scheduled commercial banks
with current regulatory level of CRAR will attract a risk- weight of 20 per cent while exposure to
non-scheduled banks/financial institutions with same level of CRAR will attract 100 per cent
risk-weight. This is discriminatory not only against non-scheduled banks of sound financial
health, but also against cooperative banks and micro-finance institutions that cater to a large
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number of urban and rural poor in India. Second, RBIs scheme encourages borrowers to remain
unrated rather than rated below a certain level (see Tables A2 and A3 in Appendix). A rating of
B- and below will have a higher risk-weight of 150 per cent, while an unrated entity will have a
risk-weight of 100 per cent. If borrowers consequently choose to remain unrated, then they
would receive a risk-weight of 100 per cent under Basel II which is same as under Basel I, thus
leading to no significant improvement in the risk-weighted asset calculation.

Issues on credit rating industry
As the SA approach of credit risk is dependent on linking risk weights to the credit ratings of an
external rating agency, credit ratings are being institutionalized into the regulatory framework of
banking supervision. This raises four important issues that need to be looked into. These are
the quality of credit rating in India, the level of penetration of credit rating, lack of issuer ratings
in India and last but not the least, the effect of the credit rating scheme on Small and Medium
Enterprises (SMEs) and Small Scale Industry (SSI) lending. In this section we elaborate each of
them. The credit rating industry in India presently consists of four agencies: Credit Rating
Information Services of India Limited (CRISIL), Investment Information and Credit Rating
Agency of India (ICRA), Credit Analysis & Research Limited (CARE) and Fitch India. These
agencies provide credit ratings for different types of debt instruments of short and long terms of
various corporations. Very recently, they have also commenced credit rating for SMEs. Apart
from that, ICRA and CARE also provide credit rating for issuers of debt instruments, including
private companies, municipal bodies and State governments.
Basel guidelines entrust the national banking supervisors with the responsibility to identify credit
rating agencies for assessing borrowers. RBI has recognized all four credit rating agencies as
eligible for the purposes of risk-weighting banks claims for capital adequacy. Further, the
following international rating agencies are recognized for risk-weighing claims on foreign
entities: Fitch, Moodys and Standard & Poors (RBI 2007b). Further, RBI has recommended the
use of only solicited ratings.

Credit rating quality:
The literature on Indias credit rating industry is scanty. However, the few studies available
point to the low and unsatisfactory quality. In Gill (2005), ICRAs performance in terms of credit
rating and provision of timely and complete information on the rated companies has been
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studied. Analysing the ICRA ratings for the period 1995-2002, the study finds that many of the
debt issues that defaulted during the period were placed in ICRAs investment grade until just
before being dropped to the default grade. These were not gradually downgraded, rather they
were suddenly dumped into default grade at the last moment from an investment grade
category. Further some defaulting issues were continuously reaffirmed as investment grade. one
is faced with the lack of objective assessment of the quality of these agencies. The few available
studies indicate poor track record of the credit rating quality in India. In addition to this, RBIs
recommendation for use of only solicited ratings causes some concern, owing to the problem of
moral hazard.

Low penetration of credit rating:
The second important issue in Indias credit rating industry is the low penetration of credit rating
in India. A study in 1999 revealed that out of 9,640 borrowers enjoying fund-based working
capital facilities from banks, only 300 were rated by major agencies. As far as individual
investors are concerned, the level of confidence on credit rating in India is very low. In an all-
India survey of investor preference in 1997, it was found that about 41.29 per cent of the
respondents (out of a total number of 2,819 respondents) of all income classes were not aware of
any credit rating agency in India; and of those who were aware, about 66 per cent had no or low
confidence in the ratings given by credit rating agencies (Gupta et al. 2001). The legitimacy
brought about by Basel II for credit ratings of borrowers will definitely increase the penetration
of the industry. However, until such time, most loans will be
given 100 per cent risk weightage (since an unrated claim gets 100 per cent weightage); thus
leading to no significant improvement of Basel II over Basel I.

Issuer ratings:
Presently credit rating in India is restricted to issues (the instruments) rather than to issuers.
Ratings to issuers become important as the loans by corporate bodies and SMEs are to be
weighted as per their ratings. Of late agencies like ICRA and CARE have launched issuer
ratings for corporations, municipal bodies and the State government bodies. Further, all
agencies, with direct support from the Government of India, have launched SMEs rating. Until
such efforts pick up rapidly, issuers will be assigned 100 per cent weightage, leading to no
74

improvement in the risk-sensitive calculation of the loans. Thus, in this account too, the
implementation of Basel II would not lead to significant improvement over Basel I.

Effects on SMEs and SSI lending:
Besides agriculture and other social sectors, Small Scale Industry is treated as a priority lending
sector by RBI. SSI accounts for nearly 95 per cent of industrial units in India, 40 per cent of the
total industrial production, 35 per cent of the total export and 7 per cent of GDP of India. In
spite of its importance on Indian economy, SSI receives only about 10 per cent of bank credit
(Table A4 in Appendix). As banking reforms have progressed, credit to SSI has fallen. The SSI
sector in India is so far out of the reach of the credit rating industry. Under the proposed Basel
II norms, banks will be discouraged to lend to SSI that is not rated because a loan to unrated
entity will attract 100 per cent risk-weight. Thus, bank lending to this sector may further go
down. In a recent initiative to promote credit rating of SMEs including SSI, the Government of
India had launched SMEs Rating Agency (SMERA) in September 2005. It is a joint initiative of
Small Industries Development Bank of India (SIDBI), Dun and Bradstreet Information Services
India (D&B), Credit Information Bureau India Limited (CIBIL) and Leeladhar (2005). 16 major
banks in India. Apart from SMERA, other rating agencies have also launched SMEs rating. As
an incentive to get credit rating, Government of India currently provides a subsidy of 75 per cent
of the rating fees to SMEs who get a rating. Net of this subsidy, the rating fees for SMEs with
annual turnover of less than Rs. 50 lakh are as follows: Rs. 19,896 for a rating by CRISIL, Rs.
19,896 for a rating by ICRA, Rs. 7,400 for a rating by CARE and Rs. 22,141 for a rating by Fitch
India. Without the subsidy, the fees are: Rs. 40,000 for CRISIL, Rs. 40,000 for ICRA, Rs. 29,600
for CARE and Rs. 42,000 for Fitch India.
According to the Third All India Census of SSI conducted during 2001-02 by the Ministry of
Micro, Small and Medium Enterprises, average output per unit of SSI in India in 2001-02 was
about Rs. 4 lakh. Thus, with the subsidy, SSI units will have to spend 2-5 per cent of their output
as fees for credit rating. Without the subsidy, the percentage of fees to output is in the range of 7-
11 per cent. This additional cost of credit rating is bound to affect the economic viability of a
large number of SSI units. While introduction of credit rating for the SMEs (including SSIs)
may, in the long run, improve the accounting practices of the SSI, there is also a possibility that
SMEs will continue to rely on the existing system of informal credit as formal credit is likely to
become more expensive due to the credit rating requirement of Basel II.
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Other issues

Extensive data requirement:
Implementation of Basel II, particularly the advanced approaches like the IRB for credit risk and
AMA for operational risk would require a huge amount of data for model building and
validation. A large number of banks in India lack reliable historical data due to late
computerization. Data on losses due to operational risk are currently non-existent. The lack of
good quality historical data on credit, market and operational risks may make migration towards
the more advanced approaches of risk management slow.

Implementation cost:

Basel II will lead to increased level of capital requirements for banks due to incorporation of
capital charges for operational risk in addition to credit and market risks. According to the recent
(April 2007) RBI circular, banks will have to increase their tier I capital by about Rs. 512,550
million within March 2009, including raising Rs. 455,210 million from the capital market to
meet the Basel II requirements of increased capital. These figures were arrived at after
conducting a simulation study of 50 public and private sector banks, consisting of 19
nationalized banks, SBI and its 7 associates, 7 new private banks and 16 old private sector banks.
Among themselves, the 19 nationalized banks will have to raise Rs. 212,110 million while the 8
SBI group banks will have to raise an estimated Rs. 100,700 million. The 7 new private banks
will have to raise Rs. 160,380 million while the equity requirement of the 16 old private banks
has been estimated at Rs. 39,360 million.
Further, extensive data requirements, up gradation of technical infrastructure, capacity building
and human resource development will translate into very high implementation cost. A Bank of
International Settlements (BIS) observation in 2004 indicated that Asian banks are expected to
spend between 7 to 10 per cent of their global IT and business operations budget on Basel II
compliance for the next four to six years. The increased capital requirements and the huge
implementation costs are likely to pose a great challenge in the path of Indias move towards
Basel II. This may in fact trigger a round of consolidation in Indian banking industry in the
coming years.


76

Implementation of BASEL II at BNP Paribas, India

About BNP Paribas
BNP Paribas is a European leader in global banking and financial services and is one of the 3
strongest banks in the world according to Standard & Poor's. The group is present in over 85
countries, with more than 168,000 employees, including 129,500 in Europe. The group holds key
positions in three major segments: Corporate and Investment Banking, Asset Management &
Services and Retail Banking. Present throughout Europe in all of its business lines, the bank's
two domestic markets in retail banking are France and Italy. BNP Paribas also has a significant
presence in the United States and strong positions in Asia and the emerging markets.
Core Values and Growth
Responsiveness:
Speed in the assessment of new situations and developments, and in identifying
opportunities and risks
Efficiency in decision making and in action
Creativity:
Encouraging initiatives and new ideas
Recognizing Contributions
Commitment:
Commitment to the service of clients and collective accomplishment
Exemplary Behavior
Ambition:
Aspiration for challenge and leadership
Desire to obtain team success in a competition where the referee is the client
77

Today, it is the largest bank in Euro in terms of total assets and second largest in terms of market
capitalization. It has a presence in 87 countries as of 2008. It employs nearly 163,000 people.
The bank has consistently been ranked in the top ten banks of the world.
Fact File
BNP Paribas has retail, corporate and Investment banking operations globally. It also focuses on
specialized financial services, asset management and insurance services. BNP Paribas Group
generates revenues through its six business divisions: corporate and investment banking,
financial services and international retail banking, French retail banking, asset
management and services, other business units, and BNP Paribas capital. Asia and
Emerging Countries accounted for 35% of client revenues in 2008.
Activities and Business Description
BNP Paribas operates through three core businesses of corporate and investment banking, retail
banking and asset management. In India the bank undertakes following business:
Corporate and Institutional Cash Management
Corporate Banking
Corporate Finance
Energy Commodity Export Project
Fixed Income
Real Estate
Structured Finance
Vehicle Management
Private Bank
Asset Management
The bank is known for its high quality services and sound risk management practices.
78

SWOT Analysis for BNP Paribas, India
Following were identified as strengths, weaknesses, opportunities and threats for the bank.

STRENGTHS WEAKNESSES
1. Global presence
2. Sound risk management system
3. Wide array of services
4. Strong market position and
reputation
1. Falling Share price for the year
2. Low growth rate of profits
OPPORTUNITIES THREATS
1. BASEL II implementation

1. Retail banking boom in India
and absence of BNP Paribas
2. Aftermath of subprime


Strengths
1. Global Presence - The advantage of having a global presence is twofold. One is that the
company does not have to incur establishment cost if it identifies any business opportunities
in those countries. And the other advantage is that it does not have to face the vagaries of
economic conditions of any one country operations.
2. Sound Risk Management system In the purview of the sub-prime crisis that hit the USA
and the demands of the New Capital Accord, this is going to be a boon for the bank. It was
least hit by the infamous sub-prime crisis and even in the circumstances of turmoil; S&P
gave stable long term rating (AA+) to the bank. While the UBS reported a loss of $ 13.5
billion and Citigroup reported a loss of $ 18 billion, Deutsche bank, HSBC and Bear Stearns
reported losses of $ 3 billion each, BNP Paribas lost only $ 197 million, confirms a BBC
news report.
79

3. Wide Array of Services - BNP Paribas provides its customers with a wide array of services
that ranges from corporate finance, export financing and advisory services to retail banking,
mortgage financing, institutional and private asset management services. Such a wide array
of services insulates the performance of the company from revenues generated by anyone
service thereby assuring a relatively stable top line for the company. In addition, it also
provides the company with access to a wider end market and enhanced cross selling
opportunities.
4. Strong Market Position and Reputation BNP Paribas has a favorable market position in
Europe and worldwide. It is the fifth largest bank in terms of market capitalization in Europe
and among the top 15 in market capitalization in the world. Forbes ranking 2008 ranked BNP
the 5
th
largest company worldwide in the banking sector. Fortune magazine ranked BNP in
top 15 of worlds most admired banks. It has been ranked the sixth most valuable brand by
the Brand Finance, 2008.
Weaknesses
1. Falling Share Price The share price of the entity has fallen through the year. Necessary
steps and optimistic market conditions are needed to correct this situation.
Opportunities
1. Implementation of BASEL II The strong and stringent credit appraisal system and
other risk management procedures that have been developed over the years will pay off
as compliance to the BASEL II norms will become easier. Not only that, because of such
advancement in the risk management systems, it will be easier for the bank to obtain
approvals of the central bank to graduate to advanced methods.
Threats
1. Retail banking boom in India and absence of BNP Paribas When all the banks,
domestic and foreign are capitalizing on average Indians increase in banking, BNP
Paribas is missing from the scene. BNP Paribas has to its credit largest retail
operations in many countries in the west. The bank needs to seize on the opportunity
that India provides for retail banking.
80

2. Aftermath of subprime The enormity of subprime has shaken the most well rooted
organizations. BNP Paribas, with its prudent practices has suffered very less in
comparison to its competitors. However, the threat of aftermath of subprime cannot
be ruled out. The shaken confidences can prove a threat if not kept in check.
Credit Risk
The bank manages its credit risk through continuous measuring and monitoring of risks at each
obligor (borrower) and portfolio level. The bank has robust internal credit rating framework and
well established standardized credit appraisal / approval processes. It is a decision enabling tool
that helps the bank to take a view on acceptability or otherwise of any credit proposal.
The internal rating factors, quantitative and qualitative issues relating to management risk,
business risk, industry risk, financial risk and project risk besides, such ratings consider
transaction specific credit enhancement features while assessing the overall ratings of the
borrower. The data on industry risk is constantly updated based on market conditions.
The bank has put in place a well structured Credit Risk Management Policy. Credit risk is
monitored by the bank on a bank wide basis and compliance with the risk limits approved by the
Credit Committee is ensured. The Committee takes into account the risk tolerance level of the
bank and accordingly handles the issues relating to Safety, Liquidity, Prudential Norms,
Exposure Limits by aligning the past experience and performance like default experience,
recovery experience etc. and also to take into consideration any regulatory and legal issues. The
credit appraisal and monitoring guidelines take into account
the counterparty
the purpose of facility
the source of repayment
It also constitutes guidelines that address specific situations related to
countries economy, political situation
industries stage of development, growth rate, certainty of cash flows
counterparties reputation, management, holding concentration
transactions purpose, repayment, maturity, legal issues
81

CRM also includes internal rating of counterparties (the policy is confidential to BNP Paribas).
In addition to Credit Risk Management Policy, the bank has also framed Board approved Loan
Policy, Investment Policy, Counterparty Risk Management Policy and Country Risk
Management Policy which form integral parting the monitoring credit risk in the bank.
In line with the regulatory requirements, the bank has put in place a well articulated policy on
Collateral Management and Credit Risk Mitigation Techniques. The policy lays down the types
of securities normally accepted by the bank for lending and administration / monitoring of such
securities in order to safeguard / protect the interest of the bank so as to minimize the risks
associated with it. It also clearly states the legalities that must be verified before any
collateralized or netting contract is made. It also defines on who is eligible to act as a guarantor
and the operational requirements for guarantees. The bank has adopted the comprehensive
approach relating to credit risk mitigation under Standardized Approach, which allows fuller
offset of securities (prime and collateral) against exposure, by effectively reducing the exposure
amount by the value ascribed to the securities. Thus, the eligible financial collaterals are fully
made use of to reduce the credit exposure in computation of credit risk capital.
Involvement of CRISIL
CRISIL was the rating agency appointed by the bank to perform rating migrations and carry out
the calculations for credit risk. The input was given by different teams of the bank as regards
various transactions, exposures etc. The data was then sorted by CRISIL into correct BASEL
asset class. Further classification of banks was done into domestic (scheduled, non-scheduled)
and foreign. Other clients were classified into Capital Market exposure and Commercial Real
Estate exposure.
Various transactions were sorted into drawn exposures, Off Balance Sheet, Repo style and OTC
derivatives. The facility under each transaction was classified into fund based, non-fund based
and investments. For the off balance sheet items, required CCFs were applied.
CRISIL compiled the external ratings available in the public domain for all the counterparties
with outstanding limits. The ratings were compiled as per the following category:
Bonds & CPs issued by Corporate and Banks
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Issuer ratings
Ratings of foreign banks (by International Rating agencies)
CRISIL also undertook various stress test analyses to ensure that capital is maintained at prudent
levels. This output (at the final and intermediary level) was constantly validated by the senior
authorities of the bank.
Market Risk
The bank has put in place Board approved Market Risk Management Policy and Asset Liability
Management (ALM) policy for effective management of market risk in the bank. Other policies
which also deal with market risk management are Investment Policy, Forex Risk Management
Policy and Derivative Policy. The policy sets various risk limits for effective management of
market risks and ensuring that operations are in line with banks expectation of return to market
risk through proper Asset Liability Management. The policy also deals with reporting framework
for effective monitoring of market risk.
Liquidity is managed through the GAP analysis, based on residual maturity / behavioral pattern
of assets and liabilities, on a daily basis based on best available data coverage, as prescribed by
the RBI. Liquidity profile of the bank is evaluated through various liquidity ratios. The bank has
also drawn various contingent measures to deal with any kind of stress on liquidity position.
Interest rate risk is managed through GAP analysis of rate sensitive assets and liabilities and
monitored through prudential limits prescribed. The bank has also put in duration GAP analysis
framework for management of interest rate risk. The bank estimates Earnings at Risks (EaR) and
Modified Duration GAP (DGAP)periodically against adverse movement in interest rate for
assessing the impact on Net Interest Income (NII) and Economic Value of Equity (EVE) with a
view to optimize shareholder value.
The bank identifies the risks associated with the changing interest rates on its on-balance sheet
and off-balance sheet exposures in the banking book from a short term (Earning perspective) and
long term (Economic value perspective) by applying notional interest rate shock up to 100 bps as
prescribed in banks ALM policy. For the calculation of impact on earnings, the Traditional Gap
83

is taken from the Rate Sensitivity statement i.e. at every reporting Friday. The limits are fixed
based on the previous years NII.
The bank has adopted Traditional Gap Analysis combined with Duration Gap Analysis for
assessing the impact (as a percentage) on the Economic Value of Equity (EVE) by applying
notional interest rate shock of 200 bps. For this purpose, a limit of (+ / -) 1.00% for the Modified
Duration Gap on the Balance Sheet is prescribed in banks ALM policy and the position is
monitored periodically on a monthly basis. Bank calculates Modified Duration Gap (DGAP) and
the impact on the Economic Value of Equity (EVE). Assets, excluding Investments and
Liabilities are grouped as per Rate Sensitivity statement and bucket wise Modified Duration is
computed for these groups of Assets and Liabilities using common maturity, coupon and yield
parameters. For investment portfolio, the Modified Duration of individual items are computed
and taken. The DGAP is calculated by the bank once in a month (based on last reporting Friday)
and is reported to ALCO and Board.
The Asset-Liability Management Committee monitors adherence of prudential limits fixed by
the bank and determines the strategy in the light of market condition (current and expected).
Operational Risk
The bank has framed Operational Risk Management Policy duly approved by the Board. Other
policies adopted by the bank which deal with management of operational risk are Information
Systems Security Policy, Forex Risk Management Policy, Policy document on Know Your
Customers (KYC) and Anti Money Laundering Procedures, IT Business Continuity and Disaster
Recovery Plan (IT BC DRP).
The operational risk management policy adopted by the bank outlines organization structure and
detail processes for management of operational risk. The basic objective of the policy is to
closely integrate operational risk management system into day-to-day risk management
processes of the bank by clearly assigning roles for effectively identifying, assessing, measuring,
monitoring and controlling / mitigating operational risks and by timely reporting of operational
risk exposures, including material operational losses. Operational risks in the bank are managed
through comprehensive and well articulated internal control frameworks.
84

Other Risks
Other risks that are identified and accounted for in case of BNP Paribas, India are:
1. Business Risk - Prospective risk to earnings arising from changes in the business environment
and from adverse business decisions, improper implementation of decisions or lack of
responsiveness to changes in the business environment. This covers the risk of fall in operating
profit due to factors not covered under credit or market risk.
2. Settlement Risk - This is defined as the risk that one party will fail to deliver the terms of a
contract with another party at the time of settlement. This could be due to default or timing
differences at settlement.
3. Strategic Risk - The risk associated with the adverse impact of strategic decisions such as
organic growth, competitive environment, mergers and acquisitions and disposals etc. is called
Strategic risk.

Capital Adequacy Ratio s maintained by BNP Paribas for year ended 31st March, 2008
The capital adequacy ratio of the Bank, calculated under the RBI guidelines (Basel I
requirement being higher) is set out below.


As at
31.3.2008
As at
31.3.2007
Tier I capital (%) 8.07 7.38
Tier II capital (%) 3.72 3.38
Total capital (%) 11.79 10.76




85

As per Basel II Norms (Pillar I)

As at
31.3.2008
Tier I capital (%) 8.67
Tier II capital (%) 3.99
Total capital (%) 12.66

Recommendations to BNP Paribas, India
BNPP India is in the process of getting RBI approval to apply Advanced Measurement Approach
for measurement of Operational Risk. Once this is done, they would have to stress test
operational risk as well to identify losses under worst case scenario.
The models for computing Operational Risk can use different scenarios for assessing risk. The
scenarios and their impact can be identified by using information obtained from the following
methods:
Internal Data
Internal Interviews
External Research
External Interview
These scenarios can be also used while stress testing the Operational risk model. Few suggested
scenarios are:
Risk of Internal Fraud
Risk of External Fraud
Risk due to employment practices and workplace safety
Risk due to client, product and business practices
Risk of damage to physical assets
Risk due to execution, delivery and process management
86

Risk of business disruption and system failures
The limitation of applying all these methods is that they require strong data bases to work on
modeling the operational risk scenarios. The data required is not only from internal sources but
also external sources so that incidents which have not hit the bank so far but have occurred
elsewhere in the industry are also accounted for while taking extreme scenarios.
Banks in India are still at a nascent stage of implementing these new regulations. Most of the big
banks are PSUs where IT systems are still being implemented and hence data collection is a huge
challenge. In such a scenario, creating a data base which covers different possibilities for stress
testing is quite difficult. Banks are currently working together with RBI to overcome this
problem soon so that they can cross over to the Advanced Measurement Method(AMA) for
operational risk measurement which would also help them in carrying out proper stress testing
and qualify to maintain optimum capital. This would free capital for the banks and get them out
of the strange condition at present where under BIA, they need to keep more capital with
increase in revenues.
In the current situation when BIA is being followed, the only method in which stress testing can
be carried out is by taking different scenarios based on different parameters which impact the
earnings of the company. Change in revenues would lead to a possible increase/decrease in
capital requirement for operational risk and indicate the amount of capital needed to maintain in
case of extreme changes in the earnings.






87

CONCLUSIONS
Before signing off I would like to reiterate the point I made in the beginning. The objective of
BASEL II norms is to encourage and support more and more advancement in terms of risk
management. It tries to bring us back to objective of primitive banking safekeeping of money
in any kind of situation. BASEL II should be seen as a challenge and an opportunity to
strengthen the organization and not a mere regulatory requirement. The more a bank can sharpen
itself with this opportunity, the more competitive advantage it will obtain.
The various models available for assessing risks should be scrutinized before their use. The exact
problems they address, the variables they take into account, the impact of change in external
environment and their sustainability to such impacts should be given due attention













88

BIBLIOGRAPHY

1. RBI master circular on BASEL II norms dated February, 2008
2. Annual Report 2007, BNP Paribas
3. ICRA article BASEL II Accord, March 2005
4. RBI circular BASEL II Credit Risk Guidelines
5. RBI circular BASEL II Market Risk Guidelines
6. RBI circular BASEL II Operational Risk Guidelines
7. RBI presentation BASEL II Pillar II
8. RBI presentation BASEL II Pillar III
9. Data Monitor Research Paper March 2005
10. www.bnpparibas.com
11. www.bnpparibas.co.in
12. www.rbi.org.in/rdocs/publications
13. http://finance.indiamart.com/investment_in_india/financial_banking_sector.html
14. http://www.rbi.org.in/scripts/AnnualPublications.aspx?head=Trend%20and%20Progress
%20of%20Banking%20in%20India
15. http://finance.indiamart.com/investment_in_india/fact_files_india.html
16. http://www.bis.org/publ/bcbsc111.pdf?noframes=1
17. http://india-financing.com/new%20nbfc%20directions.pdf