ROLES, RESPONSIBILITIES & ISSUES IN IMPLEMENTATION OF BASEL II

In terms of RBI guidelines, banks are required to commence parallel run of Basle II implementation from 01.04.2006 and full implementation w.e.f 31.03.2007.

To begin with, banks are required to adopt Standardised Approach for Credit Risk and Basic Indicator Approach for Operational Risk to compute Capital Charge w.e.f 01.04.2006.

In this connection, Our Bank has issued Circulars 245, 246 of 2005 and 41 of 2006 in respect of Credit Risk and Circular 84/2003, 184/2005 and 98/2006 in respect of Operational Risk. In the following sections, we discuss the finer points in implementation.

Credit Risk

For proper understanding of the Basel II guidelines, the subject of Credit Risk is divided into the following heads.

1. Classification of customer types & application of standard risk weights based on customer types

2. Recognition of collaterals and guarantees as credit risk mitigants

3. Treatment of NPAs

4. Treatment of Non-fund based limits


1. Classification of customer types and their risk weights
According to Basel II norms the borrowers are grouped into different customer types. Further each of the customer types attract a standard risk weight. We are furnishing below the Basel II defined customer types and the Standard risk weights assigned to them.
* For Primary dealers, Public Sector Enterprises and Corporates, risk weights have to be assigned based on the ratings given by credit rating agencies recognized by RBI. RBI is yet to inform the recognized rating agencies. Till such time RBI recognizes the rating agencies and rating of the borrowers are available, the said three categories of customer types may be treated as unrated and a risk weight of 100% would be assigned.


1.1 Sovereigns : Exposure to Sovereigns means the loans granted to Central Government and State Governments. Includes direct exposures to Central & state governments, which will attract 0% risk weight. Direct exposure on RBI, CGTSI, ECGC shall fall under sovereign exposure.

The risk weights advised above to Sovereigns are applicable to Standard assets only. Where the sovereign exposures are categorized as non-performing, they will attract risk weights as applicable to NPAs.

1.2 Exposures on Banks : The exposures on Banks have to be further categorized into those against Scheduled Banks and other than schedules Banks and risk weight should be assigned accordingly. Scheduled banks are those that are included under Schedule 2 of RBI Act 1934. All other Banks shall be classified as other than scheduled Banks.

1.3 Primary Dealers : These are dealers who deal in Government securities. The risk weight application for the exposures on Primary dealers will be based on the ratings assigned by external rating agencies recognized by RBI. Till such time RBI recognizes the rating agencies and ratings are available, they shall be treated as unrated and assigned a risk weight of 100%.

1.4 Public Sector Enterprises: Public Sector Enterprises are those which are wholly or partly (where Government’s participation in the equity of the entity is above 50% ) owned by the Government. Exposures on Public sector entities are also assigned risk weights based on the ratings given by external rating agencies recognized by RBI. In the absence of such a rating they shall be treated as unrated and assigned a risk weight of 100%.

1.5 Mortgage loans : This covers Loans secured by residential property which are either occupied by the borrower or rented/ leased out. Housing loans and Home improvement loans where residential property is taken as collateral security are to be classified under “Mortgage loan” customer type.

A risk weight of 75% is applicable for mortgage loans, only if the following conditions are fulfilled:

· The loan should be for residential purposes

· Existence of substantial margin (Value of security is 125% or above the loan amount) based on strict valuation rules.

When the value of security is less than 125%, then risk weight of 100% is to be applied.

It is important to note that all Housing Loans, Home Improvements Loans including the Housing Loans to Staff shall be classified under this Head.

1.6 Commercial real estate loans : These include loans sanctioned for acquiring real estate for commercial purpose. Since the risk of default is higher in such loans a risk weight of 100% has been prescribed (Refer HO circular 281/05 for definition of commercial real estate).

The loans sanctioned under the schemes like CanRent, Canmortgage are to be included in this head.

1.7 Regulatory Retail Portfolio : For classifying loans as Regulatory Retail portfolio the following four criteria have to be satisfied

Ø Orientation criteria: The exposure should be to an individual person or persons or to a small business (Person means any legal person having contractual capability and includes Individual, HUF, Partnership firm, trust, Pvt. LTD COs, Public Limited COs, Cooperative societies etc. In respect of small business the annual turnover should not exceed RS 50 crores). Hence it is very important that the turnover details are captured without fail in the Customer Master.

Ø Product Criteria: The exposure takes the form of revolving credits, lines of credit, personal term loans, leases, small business facilities and commitments.

Ø Threshold Criteria: The loan amount to each borrower should not exceed RS 5 crores

Ø Granularity Criteria: Aggregate exposure to one borrower should not exceed 0.2% of the overall retail portfolio of the Bank.

From the above criteria one can see that, majority of the loans sanctioned at branches will fall under this head.

The branches can arrive at the retail regulatory segment in their loan portfolio by identifying all loan schemes that satisfy the above definition.

All loans sanctioned under retail lending schemes, with the exception of Canrent/ Canmortgage (classified under “Commercial Real Estate” sector) and housing loan / home improvement loan (classified under “Mortgage Loans”), can be covered under this head.

Staff loans : Staff loans for housing would get covered under “Mortgage loans” and the remaining loans would fall under Retail regulatory portfolio.

1.8 Corporate : All credit exposures above Rs 5 crores which do not fall under any other customer type, irrespective of the constitution of the borrower are to be classified as Corporates. The risk weight to be assigned in respect of Corporate depends on the rating assigned by RBI recognized domestic Credit rating agencies. We are furnishing below the risk weights that are to be applied to Corporates based on the external ratings
RBI has come up with a tentative mapping process using which the ratings given by domestic credit rating agencies (like ICRA, CRISIL etc) can be mapped to the Standardized risk weight framework of Basel II. RBI is yet to inform the recognised rating agencies. Till such time RBI recognizes the rating agencies and rating of the borrowers are available, all loans under Corporate customer type may be treated as unrated and a risk weight of 100% would be assigned.

It is very important to note that in most of our branches, instances or cases of parties enjoying Limits/Loans above Rs 5 Crores are rare. Hence in majority of our branches, the exposure under Corporate could be either NIL or at the minimum.

However in Branches like Overseas, Industrial Finance, Corporate Service Branches and certain other VLBs, ELBs in Metropolitan centres, such exposure may be existing.

1.9 Other Assets : All other credit exposures/assets, which do not fall under
any of the 13 customer types explained above are to be categorized under this head and would attract a uniform risk weight of 100%.

As such there may not be any loans under “Others”, for the reason that almost all loans can be classified under the 13 customer types.


2. Collaterals and credit risk mitigation

2.1 Definition of collateral : Collateral according to Basel II accord means only those
recognized securities satisfying following norms:

Ø Securities taken either as prime or collateral security.

Ø Offered by borrower or a third party

Ø That aid in hedging the credit exposure against default risk in whole or in part

Ø On which banks have a specific lien and legal certainty requirements are met.

2.2 Basel recognized collateral : Basel II recognizes the following securities as eligible for treatment as credit risk mitigants, if taken either as prime or collateral

Code No
Collateral
01
Cash Margin
02
Bank Deposit
03
Gold Jewellery( benchmarked to 99.99 purity)
04
State Government securities
05
Central Government securities
06
NSC, Indira Vikas Patras & Kisan Vikas Patras
07
Debt securities rated
08
Insurance Policies
09
Debt securities unrated
10
Equities (including convertible bonds)
11
Mutual fund securities
Note: It is very pertinent to note that in respect of Standard Assets, Basel II does not recognize Land & Building, Plant & Machinery, Stock and Book Debts as eligible collateral for risk mitigation purposes.

2.3 Haircuts : The securities identified by Basel II have a definite price and this price of securities is subject to variations/changes depending upon the market forces. That is to say that there is a price volatility in the Basel identified securities. In order to take into account the fluctuations in the price, Basel II has prescribed certain cuts to the value of the securities as also the exposures to factor the volatility in the value on account of market movements. This kind of cut in the security value is referred to as haircuts. Standard haircuts have been prescribed by the accord depending on the type of security and the same are furnished below
The standard haircuts for securities issued by the Central or State Governments, Indira Vikas Patras, Kisan Vikas Patras, National Savings certificates will be the same as applicable to AAA rated debt securities.

ü Sovereign will include Reserve Bank of India, ECGC, CGTSI etc, which are eligible for 0% risk weight.

ü In cases where the exposure and the security are denominated in different currencies the standard haircut to be applied is 8%. This is prescribed in order to account for the exchange rate risk of the foreign currency.

ü Deposits with our Bank offered as security will be equivalent to cash & so applicable haircut % is zero.


2.4 Netting of collateral for capital relief : To arrive at the net exposure on which risk weights are to be applied the following details are required

ü Type of collateral

ü Value of the collateral

ü Maturity period of the collateral

ü Haircut applicable to the collateral

ü Haircut for exchange rate mismatch if exposure and security are in different currencies ( RBI has prescribed 8% haircut)

The value of the net credit exposure on which risk weight is applied is obtained by deducting the haircut adjusted collateral value from the gross exposure.


3. Guarantees & Credit risk mitigation

3.1 Basel recognized guarantor types

Basel II accord recognizes the following range of guarantors as credit risk mitigants.
3.2 Substitution approach : Substitution approach is followed in awarding capital relief on account of guarantees. That is to say, the risk weight of the guarantor will replace the risk weight of the borrower provided it results in application of a lower risk weight. Thus only guarantees issued by entities with a lower risk weight will provide credit risk mitigation effect in the form of lower capital charge.




Illustration : Let us take a credit exposure where the Borrower is an unrated corporate and is backed by a State Government guarantee.

In this case as per Basel II the Risk weight applicable to an unrated Corporate is 100% whereas for a State Govt guarantee it is 20%. Here we can substitute the risk weight applicable to the Borrower (unrated corporate) with that of the Guarantor (State Govt) as the latter attracts a lower risk weight than the borrower. That is to say the loan will attract 20% risk weight instead of 100%.

3.3 Proportional cover : Risk mitigation effect will be available to the extent of protection provided by the Guarantor and the remaining unprotected portion will carry the risk weight applicable to the borrower.

For example let us take the case of a credit exposure to an unrated corporate of Rs 1,00,000/- backed by an ECGC guarantee to the extent of 75%. In the instant case the protected portion (75% of 1,00,000) of Rs 75,000 will carry 0% risk weight whereas the unprotected portion of Rs 25,000 will carry a risk weight of 100%.

Thus in order to avail capital relief it is necessary that the following details on guarantors are captured

ü Name of the Guarantor

ü Extent of guarantee cover available

ü Customer type of the guarantor (Basel II defined customer type as given in Para I)

Like in the case of collateral, in respect of Guarantees also 8% haircut is to be applied on the Guaranteed amount for currency mismatch i.e if the exposure and the guarantee are in 2 different currencies.

4. Treatment of Non Fund Based Limits:

1. NFB exposures includes Guarantees, LCs, Bills co-acceptance and Forward exchange contracts.

2. In respect of guarantees/LCs balancing is to be taken party wise as on last day of the month and columns as per format in schedule G of Circular 41/2006 may be drawn in the balancing report itself. Bills co-acceptance exposures are also to be covered here.
3. After arriving at the credit exposure equivalent for each guarantee/ LCs, net exposure to be worked out by deducting the value of Basel recognized securities (after applying haircut) from the credit exposure equivalent.

4. In majority of the cases, margin is either in the form of cash or deposit where hair cut is Zero and hence total amount of the margin may be deducted from the guarantee/LC amount. Margin stipulated as per sanction for different types of guarantees/ LCs may be duly reckoned.

5. For each guarantee/LC security obtained as margin (only Basel defined security as mentioned above ) may be reckoned and haircut applicable may be applied to arrive at the net exposure.

6. Wherever guarantees are invoked and LCs are devolved on the Bank (conversion into FB liability) Branch should ensure that such guarantees/ LCs should not be shown as contingent liability, even if the liability is yet to be reversed.

7. After preparing working sheet for each party and various types of LCs/ Guarantees, consolidation is to be done for each customer type and type of guarantee/ LC as per Schedule G of Circular 41/2006.

Illustration: A party is having secured LC (Documentary LC) liability of Rs 50 lakhs with a margin of Rs 5 lakhs in the form of deposit with us.

Customer type is Regulatory retail (Code 12).

First, apply Credit Conversion Factor (CCF) to the outstanding liability to convert NFB exposure into FB equivalent.

CCF is 20% for Documentary LC. On applying the same the credit exposure amounts to 50 X 20% = Rs 10 lakhs. On deducting the collateral value of Rs 5 lakhs (haircut is 0%), the net exposure will be 10 – 5 = Rs 5 lakhs.

Applicable risk weight is 75% for Regulatory retail and hence RWA is 5X 75% = Rs 3.75 lakhs

11. Forward Exchange Contract: Partywise balancing of forward contracts be taken as per the format furnished in Circular 41/2006 & sent to RO for consolidation of RWA after applying CCF at their end.