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In: Business and Management

Submitted By sumeetg
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* Healthy and sound financial system plays an important role in achieving sustainable development and economic and political stability in both developed and underdeveloped economies. * Financial institutions play an important role in economic and financial environment of any country. * An essential element in the health of any financial system is the soundness of its institution. * As the value of the bank’s assets decreases or the percentage of non-performing loans increases a deduction from capital is take in an equal amount to restore the balance. Thus, capital acts as a source of funds to bear risks and absorb losses, covering any imbalance caused by a fall in the value of assets. * The level of capital funds required to support the institutional structure and to provide protection against unanticipated and excessive losses is known as capital adequacy * Capital adequacy is the most crucial element within bank supervisory systems * Systemic risk or the contagion effect means failure of one bank leads to possible collapse of several other financial institutions. * A liquidator is the officer appointed when a company goes into winding-up or liquidation who has responsibility for collecting in all of the assets of the company and settling all claims against the company before putting the company into dissolution * G-10 countries include Belgium, Canada, France, Germany, Italy, Japan, The Netherlands, Sweden, Switzerland, The United Kingdom and The United States. * G-10 countries along with Luxembourg , formed the “Basel Committee on Banking Supervision “ (BCBS) under the aegis of the Bank of International Settlements (BIS) in Basel for laying down the standards for banking regulations. This was because of the failure of German bank Herstatt in 1974 which was an under capitalized bank. * In July 1988, the Basel Committee came out with a set of recommendations aimed at introducing minimum levels of capital for internationally active banks. Though these proposals were not legally binding on the signatory countries, more than hundred supervisors from different countries agreed to implement the Basel norms with modifications suited to their domestic economies. This first series of recommendations by Basel Committee are popularly known as Basel I norms. * These norms required the banks to maintain capital of at least 8 per cent of their risk-weighted loan exposures. * The norms were successful in improving the capitalization ratios of the banks worldwide. In India, the banks were required by the Reserve Bank of India to maintain a higher capital-to-risk-weighted-assets ratio (CRAR) of 9 per cent. * One of the main drawback of these norms were that it focused primarily credit risk and treated all types of borrowers under one risk category regardless of credit worthiness-one size fits all approach. Capital requirement of ‘AAA’ rated exposures was the same as ‘BB’ rated exposure, the banks tended to acquire low quality/high return assets. It lacked incentives for implementing credit risk mitigation techniques. Also it didn’t considered operational risk. Risk weights were calculated based on type of loan irrespective of credit worthiness of borrower. This means loan to govt bodies carried 0 % risk whereas 100% in case of corporate finance. * Because of these drawbacks, Basel committee came up with new reforms known as Basel II norms. * These norms were more complex, comprehensive, more risk sensitive and rely heavily on data analysis for risk measurement and management. * The norms were based on three pillars of Capital Requirement, Supervisory Review and Market Discipline. * For India, these norms provide massive opportunities in the form of software services, outsourcing and consultancy services. * Securitization, in its most basic form, is a method of financing assets. Rather than selling those assets "whole," the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or "spinning off," a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now. A very basic example would be as follows. XYZ Bank loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has invested in the success and/or failure of those 10 home buyers- if the buyers make their payments and pay off the loans, XYZ makes a profit. Looking at it another way, XYZ has taken the risk that some borrowers won't repay the loan. In exchange for taking that risk, the borrowers pay XYZ a premium in addition to the interest on the money they borrow. XYZ will then take these ten loans, and put them in a pool. They will sell this pool to a larger investor, ABC (typically the SPV). ABC will then split this pool (which consists of high risk loans and low risk loans) into equal pieces. The pieces will then be sold to other smaller investors (as bonds). * Some of the features were responding dynamically to changes in credit quality, adapting to market and product evolution, required maintaining capita even for operational risk like enhancement in technology, etc. * All banks in India having presence outside India and all foreign banks operating in India are required to migrate to Basel II framework by March 2008. The remaining banks are required to migrate to Basel II by March 2009. * Some of the banks which adopted till match 2008 are Allahabad Bank ,Andhra Bank, Axis Bank, Bank of Baroda, Bank of India, Canara Bank, SBI, UCO,UBI, ICICI, HDFC, PNB * A bank always faces the risk that some of its borrowers may renege on their promises for timely repayments of loan, interest on loan or meet the other terms of contract. This risk is called credit risk. *

To calculate credit risk: Expected Loss (EL) on a loan = Exposure at default (EAD) * Loss given default (LGD) * Probability of Default (PD) Where EAD=Total loan given LGD=loan remaining to be paid PD=avg percentage of borrowers that default in that rating * To calculate min. capital requirement under credit risk, there are 3 approaches:
a) Standardized Approach
b) Internal Rating Based (IRB) Approach(Foundation)
c) Advanced IRB Approach * In standardized approach, risk weight is calculated based of the rating given by any of the approved “External Credit Assessment Institutions (ECAIs)”. The following four rating agencies have been approved by RBI for domestic exposure: CARE, CRISIL, FITCH, and ICRA. For external exposure, the following three agencies have been approved: FITCH, Moody’s and Standard & Poor’s. Further, rating should be ‘solicited rating’ by the borrowers. Here credit Risk is determined by reference to the public rating of the borrower Min. Capital Requirement = 8% * Loan amount * Credit risk weighting * In 2nd approach, the banks have their own internal rating system. It requires 3-5 yrs of data to calculate PD. * In 3rd approach, It requires five year data for computing PD, seven years data for computing Loss Given Default (LGD). The above ratings are applicable to corporate exposure, i.e., exposure above Rs. 5 cr: and exposure of less than Rs. 5 cr is classified as retail exposure. For retail exposure, risk weights have been prescribed under the RBI policy. * Operational risk arises due to failed operations within the bank, server crash, people leaving job, etc. * The pillar 1 stipulates the following approaches for assigning capital to meet operational risk:
a) Basic Indicator Approach
b) The Standardized Approach (TSA)
c) Advanced Measurement Approach (AMA) * According to 1st approach, capital requirement should be 15% flat of gross average income, positive for the last three years. 15% is known as beta. * According to 2nd approach, each bank business is divided into 8 business lines and beta for each line is assigned. Then capital requirement of each business line is calculated since beta and gross income of each line is known. Here, avg gross income is calculated considering 3 yrs. Then capital requirement of that business line is selected which is maximum. The Bets factors are displayed in table Business Lines | Beta Factors | Corporate Finance (β1) | 18% | Trading and Sales (β2) | 18% | Retail banking (β3) | 12% | Commercial Banking (β4) | 15% | Payment and settlement (β5) | 18% | Agency Services (β6) | 15% | Asset Management (β7) | 12% | Retail Brokerage (β8) | 12% | * According to 3rd approach, banks are permitted to use their own internal model to calculate the required capital, subject to, of course, their compliance with the criteria prescribed by the committee, in addition to what has been prescribed under TSA. Here, loss which happens due to operational risk is considered for last 5 years. * Statutory liquidity ratio - banks are required to invest in liquid assets such as cash, gold, government and other approved securities. This % is 25% for Indian banks which was increased from 24 to 25 on 9th nov, 2009. Such investments are risky because of the change in their prices. This volatility in the value of a bank's investment portfolio in known as the market risk, as it is driven by the market. The change in the value of the portfolio can be due to changes in the interest rates, foreign exchange rates or the changes in the values of equity or commodities. * The pillar 1 stipulates the following approaches for assigning capital to meet market risk:
a) Standard duration Approach.
b) Model Approach. * In the 1st approach, duration of the investment is taken into account and accordingly capital requirement is set. * In the 2nd approach, It is based on internal risk assessment models developed by bank. Banks in India are not yet ready for this approach.In the initial stage, all banks are required to follow Standardized Approach in credit risk, Basic Indicator Approach in operational risk, and Standard duration Approach in market risk. Mitigation to higher approaches will require RBI permission. Higher approaches are more risk sensitive and may reduce capital requirement for banks following sound risk management policies.

* Pillar 2 says that banks should have better risk management practices so as to minimize risk.

* It is based on 4 principles that the regulators like RBI should follow: These principles relate to periodic checking of CAR and capital levels, making management involve in bank business, maintaining CAR above min level, intervene if bank is operating below min levels and if it goes below then taking appropriate actions like raising capital, restricting ban business,etc

* Pillar 3 requires banks to provide adequate disclosures to various audiences like rating agencies, customers,etc. Disclosures like capital structure, risk assessment and risk management processes, etc. The third pillar of market discipline will force the banks to share the critical performance and systems related information with the stakeholders, which would improve corporate governance and operational transparency substantially

* Issues and Challenges of basel 2 norms: 1. Risk management system: Heavy changes in policies, bank structure,etc 2. Capital adequacy assessment process: No proper procedure to calculate risk that may arise over a period of time. 3. Technology upgrade: Many softwares evolved to calculate risk but bank employees lack knowledge in using it. 4. Data requirement and data management 5. Management issues: differences in stakeholders 6. Risk management education: employees learning theory and practical concept of risk 7. Capital requirement: large capital required for technological advances and changes in policies. 8. Rating requirement: very few rating agencies and many companies unrated. 9. Choice of alternative approaches: one bank using IRB approach and one bank using standardized approach. Standardized will require lower capital requirement and hence will accept the project. 10. Absence of historical database 11. Disadvantage for smaller banks: not enough resources to implement this sytem. * Advantages of basel 2 norms: 1. Better business decisions: Right calculation of risk gives ban confidence and this helps in taking better decisions 2. Better risk management: helps in minimizing losses 3. Market discipline: banks will maintain market discipline by giving appropriate disclosures. 4. Opportunity for IT and consulting companies: new technology implementation and to teach employees.

Impact of Basel II:-

1. Additional capital requirement

2. Impact on Loan Pricing, Portfolio Composition, Bank Performance and the Lending Process as a Whole

3. Enhanced Risk Management

4. Enhanced Role of Regulator

5. Impact on Business Model

6. Lead to Possible Consolidations in the Banking Industry

7. Cost Impact on Borrowers

* The central theme of Basel II accord is risk management and transparency of operations. * Foreign banks and Indian banks having foreign presence should migrate to above selected approach from 31st march 2008. All other banks commercial banks are encouraged to migrate from 31st march 2009 * Priority sector lending which was seen as a thread is now seen as opportunities…sectors include agriculture, education, sme, etc.

M&A Trend in Indian Banking Industry:-
Mergers in the Indian banking sector can mainly be classified into 2 types;
1. M&A’s due to financial difficulties 2. Strategic Mergers

Bank | Merged with | Year | Bank of Behar | SBI | 1969 | National Bank of Lahore | SBI | 1970 | Eastern Bank | Chartered Bank | 1971 | Krishnaram Baldeo Bank | SBI | 1974 | Belgaum Bank | Union Bank | 1976 | Lakshmi Commercial Bank | Canara Bank | 1984-85 | Bank of Cochin | SBI | 1984-85 | Miraj State Bank | Union Bank | 1985 | Hindustan Commercial Bank | PNB | 1986 | Traders Bank | BOB | 1988 | United Industrial Bank | Allahabad Bank | 1989-90 | Bank of Tamihad | Indian Overseas Bank(IOB) | 1989-90 | Bank of Thanjavur | Indian Bank | 1989-90 | Parur Central Bank | Bank of India (BOI) | 1989-90 | Purbanchal Bank | Central Bank of India | 1990-91 | New Bank of India | PNB | 1993-94 | Bank of Karad | BOI | 1993-94 | Kasinath Seth Bank | SBI | 1995-96 | Bari Doab Bank | OBC | 1997 | Punjab Co-operative Bank | OBC | 1997 | Bareilly Corporation Bank | BOB | 1999 | Sikkim Bank | Union Bank | 1999 | Benaras State Bank | BOB | 2002 | Nedungudi Bank | PNB | 2003 | South Gujarat Local Area Bank | BOB | 2004 | Global Trust Bank | OBC | 2004 | United Western Bank | IDBI Bank | 2006 |

Strategic M&As in Banking—merger of strength…purely strategic

Bank | Merged with | Year | Times Bank | HDFC Bank | 1999 | Bank of Madura | ICICI Bank | 2001 | ICICI | ICICI Bank | 2002 | Bank of Punjab | Centurion Bank | 2005 | Lord Krishna Bank | CBoP | 2006 | CBoP | HDFC Bank | 2008 |

Mergers are important since it helps in targeting different geographical areas, diversified products, diversification of risks, less competition, large customer base, etc.
Foreign ownership in government banks (foreign direct investment and portfolio investment) is capped at 20%. However, foreign investment in the private sector banks is allowed up to a maximum 74%.. If we were to talk about a few real strong banks then they would definitely be SBI, Punjab National Bank (PNB), Canara Bank (Can B), Bank of Baroda (BOB), Bank of India (BOl), and Union Bank of India (UBI) as key world-class banks amongst the Indian public sector banks
With the exception of the SBI, there are large banks in each region—PNB and UBI in north India, Canara Bank in south India, BOB and BOI in west India. We also see that there are no major banks in East India so may be they can come together to form a big bank One of the conclusion is It also may lead to possible consolidation in the Indian Banking Industry which is the need of an hour. There will be a huge opportunities for IT and consultancy companies as the banks all over the world will have to make huge investments in technological up gradation in order to be Basel II compliant. Also, there is a great scope for credit rating agencies under this accord. Basel 2 will ensure a world class management and corporate governance practices, thus contributing towards a more robust and healthy banking and financial system

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