Rbi Questions Basle Prescription

In its response to the consultative paper issued by the Basle committee on Banking supervision (June 1999), the Reserve Bank of India (RBI) has taken a very pragmatic view of the rigidities within financial markets in emerging economies. Basically, the central bank has said that the main drawback of the 1988 accord was its one-size-fits-all approach and it will be equally futile to work out a global framework on substantially the same principle, though taking on record a wider variety of banking risks.

The committee had recommended a three-pillar approach to supervision, including setting up minimum capital requirements, supervisory review of banks' capital adequacy and internal assessment processes, and effective use of market discipline (see Money Manager, June 10, 1999).

 

The RBI circulated its response ahead of the March 31, 2000 deadline set by the committee.

The RBI has chosen to speak broadly in terms of emerging market issues. For instance, it says "because of the dependence of these markets on the agricultural sector and its seasonality, low competitiveness, vulnerability to external sector, low technical skills of the market players ought to be recognised and properly addressed."

That sounds odd, especially when the core issue in the banking system is risk, and the allocation of minimum adequate capital to address the known risks. Identification of country-specific risk could well be separated from the issue of benchmark capital allocations for each category of risk.

In aligning itself with emerging markets, the RBI has put across a confused picture. For instance, on market discipline, the third pillar in the framework, the RBI records its reservations on the market's ability to comprehend and assimilate data!. "National supervisory authorities should also consider the ability of the market to logically interpret the available information. Otherwise, there is a possibility of over reaction to insignificant events or factors, which can destabilise the system," the RBI has said.

Surely, this is an observation on the generic issue of market over reactions and not a RBI viewpoint on the maturity of Indian markets (though that too has often been doubted). Perhaps it would have been better to focus on country-specific issues rather than carry the can for other countries.

Indeed, the International Monetary Fund (IMF) and the World Bank are working out a set of acceptable macro prudential indicators (MPI) which could perhaps have a bearing on the risks of the banking system. Following the Asian crisis, the group of G-22 finance ministers and central bank governors submitted a report of the working group on strengthening financial systems in October 1998. The working group recommended that financial sector surveillance be anchored to the IMF surveillance process, with support from the World Bank and elsewhere.

As a result, the IMF-WB combine set up the financial sector assessment program (FSAP) and the related, financial system stability assessments (FSSAs), effective May 1999. The RBI's concerns will fit into the IMF-WB group initiative rather than the Basle committee work.

The RBI's response is a pretty good indicator of what is in store for domestic banking, even though the package may not find full reflection in the final Basle accord.

Three issues are very clear. Firstly, the RBI has taken the view that subsidiaries established by banks should be subjected to full capital adequacy on a "stand alone basis as an alternative." In para 6.1.1 of the document (available on the net at www.rbi.org.in), the RBI says: While appreciating the committees' proposal to include, on a fully consolidated basis, holding companies that are parents of banking groups to prevent double gearing of capital, the RBI feels that the application of the framework on stand alone basis with full deduction from total capital should continue to be an alternative, where banks are of simple structure.

RBI proposes full supervisory discretion on the issue of adjustments to capital. "The choice of alternative method should be subject to supervisory discretion," the RBI says, illustrating it with the special case of banks owning minority stakes in other banks and financial institutions. " The RBI is of the view that minority stakes taken up by banks in the equity of other banks/financial institutions (FIs), as one of the promoters, which are held for strategic reasons on long-term basis and held in the banking book alone should be deducted from the investing bank/FI's total capital," the central bank says.

This takes into account the special case of cross-holdings within the banking sector, especially by way of Tier-II capital. The RBI says the 1988 accord's discretionary dispensation should continue provided the cross-holdings are within the prescribed `material limit'. "Any excess investments above the material limit cold be deducted from the investing bank/FI's total capital," the RBI says.

Secondly, the RBI has categorically rejected the committee's recommendation to accord greater importance to ratings assigned by external rating agencies.

"The RBI considered in depth the issue of relying on external credit rating agencies which are located mainly in the United States, as the basis for assigning preferential risk weights and it is of the firm view that assigning greater role to the external rating agencies in the regulatory process will not be desirable, for different rating agencies resort to different parameters for risk evaluation, which are often not transparent,"

(para 6.3.2).

The RBI goes on to hammer its case that even on sovereign ratings, two of the most widely known agencies, Moody's and Standard and Poor's agreed only 67 per cent of the time in the case of double-A and above rated countries. In the case of investment grade ratings, the two agencies agreed only 56 per cent of the time, and for ratings below investment grade, they agreed only 29 per cent of the cases examined.

RBI emphatically makes the point that "the low level of agreement below the investment grade is significant for emerging markets, as most of them are currently rated under this category."

"The proposed role requires reconsideration particularly so in the emerging market economies which are assigned sovereign credit ratings which put an upper limit to corporate credit ratings, irrespective of their individual credit worthiness and past debt service record," the RBI says.

But in a pragmatic realisation that the banking sector needs inputs from the outside world, which also takes into account seasonal factors and other externalities, the RBI has taken the view that domestic rating agencies should be assigned a greater role in the risk assessment of banking book assets, subject to adequate safeguards.

The RBI says if banks want to rely on external ratings, they must access two assessments of the same category to avoid rating shopping.

Thirdly, on the supervisory review process, the second pillar of the proposed framework, the RBI says it is in complete agreement that "each financial entity critically assess its capital adequacy and future capital needs in relation to its risk profile and that supervisors should have a method of reviewing internal capital adequacy assessments."

But in the same breath, it says the burden of estimating economic capital may not be mandated on smaller banks, which are not offering complex products and operating predominately in domestic/segmented markets." This is again an odd position to take, especially after its experience of loading capital adequacy guidelines on the non-banking finance companies (NBFC sector), and lately on urban cooperative banks.

In fact, the so called smaller, segmented banks should be the source of greatest concern to the central bank. Though not officially, the larger banks rest under the "too big to fail" umbrella. Pre-emptive bailout operations preclude the possibility of a bank failure. But the smaller ones have no protection. As has happened with some of the NBFCs and Nidhis, the effect of failure is no less debilitating.