New capital adequacy framework: RBI's views

THE BASEL Committee on Banking Supervision, which sets global standards for regulation and supervision, had released in June 1999 a Consultative Paper on ``A New Capital Adequacy Framework'' for comments by central bankers, market players and other interested parties. The new framework is designed to rectify shortcomings of the 1988 accord and also in addressing the in- built deficiencies in the current risk weighting model. The new framework calls for better alignment of regulatory capital with underlying risks, by replacing the current broadbrush approach with preferential risk weighting. The new framework also extended its scope to provide for explicit capital charge for other risks, namely, operational risk and interest rate risk in the banking book for the banks where interest rate risks are significantly above average (outliers).

The new framework is built on a three-pillar approach - minimum capital requirement, supervisory review and market discipline to strengthen the international financial architecture.

The adoption of the new framework in the present form will have important implications for emerging markets and will call for structural changes in the current regulatory and supervisory standards. Recognising the implications of the new framework on emerging market economies, an internal working group was constituted in the Reserve Bank of India to examine the impact and applicability, scope for and problems in implementation and the time span within which the framework could be adapted to Indian conditions. Based on the recommendations of the group, the RBI has finalised and forwarded its comments on the new framework to the Basle Committee, and can soon be accessed at RBI's website www.rbi.org.in.

The views of the RBI, in brief, are:

While appreciating the Basel Committee's initiative in addressing the rigidities of 1988 Accord and the three-pillar approach, the RBI is of the view that some of the recommendations require modifications/flexibilities to fully reflect the macro economic environment, structural rigidities and concerns of emerging markets. Regarding the scope of application, it feels that where banks are of simple structure and have subsidiaries, the Accord could be adopted on stand-alone basis with the full deduction of equity contribution made to subsidiaries from the total capital. There is also a need for discretion to national supervisors to prescribe a material limit up to which cross-holdings could be permitted.

External rating not favoured

The RBI considered in depth the issue of relying on external credit rating agencies as the basis for assigning preferential risk weights on country exposure, bank exposure and exposure to other sectors. Considering the track record and differences in the attribution of ratings, lack of uniformity in selection of parameters, it is of the view that assigning greater role to external rating agencies in the regulatory process would not be desirable. Instead, it prefers that the assessment made by domestic rating agencies that have upto-date and ongoing access to information on domestic macro economic conditions, legal and regulatory framework etc. could be a better alternative source for assigning preferential risk weights for banking book assets (excluding claims on sovereign), subject to adequate safeguard.

This alternative would provide national supervisors greater access to quality of assessment sources and methodologies used by various rating agencies. The RBI also favours that greater reliance needs to be placed on internal rating-based approaches of banks which can be structured under an acceptable framework. Such an approach would encourage banks to refine their risk assessments and monitoring process.

The central bank welcomes the Basel Committee's approach to dispense with the grouping of countries into OECD / non-OECD for assigning risk weights. It also endorses the committee's proposal to provide discretion to national supervisors to give modified treatment for banks' exposure to their own sovereign, denominated in domestic currencies and funded in same currencies.

While appreciating the committee's proposal to distinguish financial institutions on the basis of their credit quality, the RBI is of the view that risk weighting of banks should be de- linked from that of the sovereign in which they are incorporated. Instead, preferential risk weights in the range of 20-50 per cent, on a graded scale could be assigned on the basis of risk assessments by domestic rating agencies. As regards the proposal to assign favourable risk weight to short-term claims, the RBI is of the view that this proposal will seriously jeopardise the stability of international financial architecture, since from the macro economic point of view, short-term claims could not be a perfect option as this will lead to regulatory arbitrage through roll-overs, concentration of short-term liabilities and serious asset - liability mismatches, which could trigger systemic crises. The proposal to link the banking supervisor implementing / endorsing the Core Principles for Effective Supervision for lower risk weights, is also not desirable.

As regards the Committee's proposal to assign risk weights to claims on corporates on the basis of ratings, it is observed that the population of rated entities is very small in many countries, especially in emerging markets. RBI is of the view that preferential risk weights could be assigned to corporates, above a material limit, on the basis of risk assessments by domestic rating agencies. Further, risk weight should solely be dependent upon the credit ratings and the proposal to link it with the risk weight of the sovereign of the corporate's country of incorporation needs reconsideration.

While agreeing with the Committee's proposal that credit risk modelling could have the potential to be used in the supervisory process, the adoption of such models as an alternative for setting capital charge in emerging markets is severely constrained by data limitations and model validation. The modifications and the parameters for identifying outliers for mandating explicit capital charge for interest rate in the banking book needs further discussion. The RBI fully endorses the Committee's proposal that each financial institution should critically assess its capital adequacy requirements and that supervisors should have methods for such assessments by financial institutions. While agreeing with the Committee's views on increased disclosures and enhanced transparency, national supervisors should consider the ability of the market to logically interpret the information.

In view of the less developed institutional and accounting infrastructure, many emerging market economies may not be able to implement all the proposed measures, as and when they take final shape and the new framework finally replaces the 1988 Accord. Specifically, emerging markets would need certain transition period to implement the proposals in respect of consolidation of accounts and assigning capital on a consolidated basis, setting benchmarks and approving the rating methodologies of domestic rating agencies, improving the technical capabilities of supervisors and financial institutions, mapping of individual ratings of banks with the regulatory risk weight baskets, assigning of explicit capital charge for interest rate risk in the banking book and other risks, for example, operational risk, estimating economic capital and introducing more disclosures on risk-based capital ratios, etc. Basel Committee may consider these constraints and explicitly provide for sufficient transition time for emerging markets in the final framework.

Alpana Killawala

General Manager, RBI

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