Section 5 (b) of the Banking Regulation Act, 1949 defines “banking” as a means of accepting, for the purpose of lending or investment, deposits of money from the public, repayable on demand or otherwise, and withdrawal by a cheque, draft, order or otherwise. It is an industry that handles cash, credits, and other financial transactions of customers. It is a financial institution upon which people heavily rely on the purposes of depositing their cash, taking loans, or any other activities. Due to varied operations, ‘Risk’ and ‘Returns’ are the two core pillars of the banking sector. Owing to the risk factors that this industry faces worldwide, certain international standards, known as ‘Basel’ norms were introduced in order to help the banking centers across the globe strengthen their system for better financial management.
Risk Management in The Banking Sector
A bank has two important roles at its disposal- mobilizing hard-earned public funds safely to one side and meeting the economy’s need for funds for its development. Today, the risk factors surrounding the banking sector is increasingly drawing our attention toward it. There are several types of risks endangering a banking sector; to name a few-
- Credit Risk is the risk of default of payment on the part of a borrower.
- Market Risk is the risk arising out of fluctuation in market prices due to various reasons, like fall or rise in exchange rates, imbalance in the assets and liabilities of a balance sheet, changes in interest rates, etc. There are various types of Market Risks such as Foreign Exchange Rate risk, Gap risk, Interest Rate Risk, and so on.
- Operational Risk could arise in a bank due to the failure of the operating system because of various reasons, such as natural calamity, robbery, system failure, etc.
- Liquidity Risk arises when a bank is unable to meet the financial needs by converting its assets into cash without incurring a loss in its income or capital in the process.
- Systematic Risk is that risk which occurs when the failure of one financial institution has a systematic chain effect on other financial institutions as a whole.
- Strategic Risk occurs when there is a fundamental economic or political shift. This has an impact on the functioning of the banking sector as well as the other financial institutions. Few examples of such scenarios could be the fall of the Berlin Wall, the European Economic Crisis, etc.
- Reputation Risk is the loss of potential credibility of an institution’s business practices, which might adversely impact its customer’s trust, leading to a loss in its customer base, public image, etc.
- Business Risk mostly involves the risk that a bank willingly takes to create a competitive advantage, and value to its shareholders. It mostly pertains to the product market in which the bank operates, technological innovations, etc.; this mostly to gain a fair share of advantage in the market by driving customers toward it by creating a space of trust in its functioning ability.
Generally, the term ‘risk’ and ‘uncertainty’ are synonymously used, but that’s not the usual scenario since both are fundamentally different. While uncertainty is unquantifiable, the risk is a quantifiable certainty. Post liberalization and privatization, the banking sector has been facing tremendous competition not just domestically, but internationally too. Due to disintermediation and deregulation post-1990, banks have been functioning autonomously in lending, investments, etc., but subsequently, it has become an arduous task for them to manage their profits and risk amidst the current, sometimes unforeseeable, developments.
Effective Management of Risks in Banking
Certain traditional techniques of risk management that existed prior to Basel norms introduction are:
- Credit Scoring is the method by which banks perform a credit check on the prospective borrowers to assess their creditworthiness.
- Collateral is a way of seeking security over some assets of the borrowers.
- Guarantee is a way to seek assurance of repayment of loan, from a third party, in the event the borrower fails to do so.
- Diversification is usually followed by banks when lending money to a small number of borrowers (or kinds of borrower), and chances of facing risk is high. They reduce this risk by diversifying the borrower pool.
Apart from this, sometimes banks also follow the method of hedging, an investment strategy to reduce the risk of incurring losses, by lending money or monetary instruments at an estimated price. Irrespective of all this, the risk factor persists, and therefore, to strengthen functioning of the banking sector against unexpected losses, the Basel Committee was formed.
History of The Basel Committee
The first major institution established for management of financial institutions across countries and their functioning was the ‘Bretten Woods’ system of monetary management. It laid down the rules and standards that were to be followed for the transaction of money, be it borrowing, lending, etc. among countries, in order to stabilize the economic situation that had worsened during the world wars. The breakdown of the Bretten Woods system led to casualties in 1973. Post this, the central-bank governors of the G10 countries established the Basel Committee on Banking Supervision [BCBS] in 1974. It meets at the Bank for International Settlements in Basel, Switzerland.
Basel Norm’s Implication In The Indian Banking Sector
The Basel Capital Accord (the 1988 Accord) was approved by the G10 Governors and released to banks in July 1988.The 1988 Accord called for a minimum capital ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992. Ultimately, this framework was introduced not only in member countries, but also in virtually all other countries with active international banks. Soon after its implementation, members realised that the framework of the Basel 1 Accord was weak due to various limitations, like addressing the market risks, etc. hence, a new set of modified rules were introduced in 2004 in the form of Basel 2 norms. Following were the components of the Basel 2 model:
(i) Minimum capital requirements, which seek to develop and expand the standardized rules set out in the 1988 Accord;
(ii) supervisory review of an institution‘s capital adequacy and internal assessment process; and,
(iii) Market discipline for effective use of disclosure as a lever to encourage sound banking practices.
This second Accord, the Basel 2 norms used very advanced methodologies and probabilistic methods for strengthening the banking sector. But before the 2008 recession hit the world, the banking sector was in urgent need for strengthening of its Basel 2 framework. It was a financial crisis for the banks with too much leverage and liquidity buffers followed by poor governance, risk management, and incentives.
Scope of Basel 3 Guidelines Implementation
The Basel 3 guidelines were developed in response to the deficiencies observed in the risk management during 2007-08. These recommendations are supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage. The Reserve Bank of India has not yet implemented the Basel 3 recommendations which were passed in December 2010. Following are some of the salient features of the Basel 3 guidelines that reflect how it would benefit India’s banking sector-
- Better Capital Quality provides a much stricter definition of capital, whereby better quality capital would mean higher- loss-absorbing capacity.
- Capital Conservation Buffer requires banks to hold capital conservation of 2.5%, which would act as a cushion for absorbing higher losses in the future- a preventive mechanism.
- Counter-Cyclical Buffer has been introduced with the objective of increasing capital requirements during good times and decreasing it during bad times; the buffer value ranges from 0 % to 2.5%.
- Minimum Common Equity and Tier 1 Capital Requirements have been raised under Basel III from 2% to 4.5% of total risk-weighted assets. While the minimum total capital requirement shall remain at the current 8% level, the required total capital would increase to 10.5% when combined with the conservation buffer.
- Leverage Ratio is like a safety net; it is the relative amount of capital to total assets (not risk-weighted). This aims to put a cap on the swelling of leverage in the banking sector on a global basis.
- Liquidity Ratio under two categories of Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) were to be introduced in 2015 and 2018, respectively.
- Systemically Important Financial Institutions (SIFI) provides 3 options for implementation, like capital surcharges, contingent capital, and bail-in-debt, owing to the fact that banks are supposed to have the loss-absorbing capability.
Challenges for India So far, the Reserve Bank of India has not been able to fully implement the Basel III norms in India; only the first requirement for keeping 8% capital aside (which is lower than the 10.5% mark after adding the buffer value of 2.5%) could be met. In India, most of the profits for banks come from loans; besides this, the banks are required to meet the Liquidity Coverage Ratio along with the statutory requirements of RBI’s Statutory Liquidity Ratio and Cash Reserve Ratio. This is an arduous task for the banks since they have to increase capital, liquidity, and reduce leverage, as per Basel III norms. The current situation is not very viable to be compliant with those norms as it would require banks to keep aside more money, resulting in stressed balance sheets. But it is important that RBI accelerates the process of adopting the Basel III norms because then the capacity of Indian banks to increase capital with better risk management would further aid in absorbing any unforeseeable losses in the future that would havoc the functioning of the banking sector