The Chartered Accountant

DECEMBER 2008 980 THE CHARTERED ACCOUNTANT
AUDITING
New standards are an amalgam of international best practices and call for
introduction of advanced risk management system with enterprise level
applications. Hence it has become a daunting task to craft the required level
of technological architecture, and assemble human skill across an institution
undertaking such appraisal and across the industry which is dragging to
overhaul itself. Also the managerial cadre has to be properly trained for
understanding of critical issues for risk profiling of supervised entities and
validating and guiding development of complex IRB models.
Huge implementation cost may also impact profitability
for smaller banks who are striving to meet the Basel
II standards. The new framework is very complex and
difficult to understand. It calls for revamping the entire
management information system and allocation of
substantial resources. Therefore, it may be out of reach
for many smaller banks. As Moody's Investors Services
puts it, "It is unlikely that these banks will have the
financial resources, intellectual capital, skills and large
scale commitment that larger competitors have to build
sophisticated systems to allocate regulatory capital
optimally for both credit and operational risks.”
To top it all, banks may have to keep additional capital,
considering the possibility of under estimation of risks
and the quality of risk management, as stated in the
guidelines.
Lack of Specific Guidelines
When the Bank for International Settlements (BIS)
proposed guidelines on the treatment of derivatives
and other "trading book" issues, those guidelines ran
smack up against provisions of the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005 in
US. Provisions of the new U.S. law, which takes effect
October 17, 2008 enable companies to net out transactions
between counterparties and across derivative
product lines. The affected products include repurchase
agreements, credit derivatives, energy derivatives, and
interest-rate swaps. BIS provisions — part of the Basel
II package of international capital guidelines — take a
much more restrictive approach to cross-product netting
than do the U.S. bankruptcy law or similar European
legislation disallowing such cross netting. Hence the
rule makers have themselves built in anomalies within
the stipulated regulations resulting in conflicts in the
regulatory regime of the country which was used as a
framework for designing the global Basel accord and
is now our issue of contention. This issue with BIS
implementation in US has been mentioned here to describe
that issues with BIS are not only with us but with
the makers of the rules also. It's not up to these regula-
tors to be telling us from Mount Everest what to do
when they themselves are confused about the implementation
of their own superseding guidelines.
Above all, these norms provide only broad principles
to help banks in developing their Internal Capital Adequacy
Assessment Process. However, this situation will
offer professional opportunities in the form of consulting
contracts for the Chartered Accountant community.
A Mixed Bag of risks
The guidelines issued on Supervisory Review Process
(SRP) 5 of Basel II accord ask banks to make provision
for risks relating to credit concentration, liquidity, settlement
risk, reputation, strategy, and under-estimation
of credit risk that were not specified earlier. Providing
an assortment of risks to banks not only makes this
daunting task more demoralizing but gives room to
all possible errors and assumptions on which the new
banking accord is being predestined.
toppling of interest Margins
Under the Basel II credit rating is not mandatory but
provides huge capital savings to the banks with rated
portfolios. In case a bank chooses to keep some of its
loans unrated, a provision of a flat risk weight of 150
per cent for credit risk on such loans is imposed. After
April 1, 2008 fresh unrated disbursals and renewals
greater than Rs.500 million attract a risk weight of 150
per cent. This minimum size will be further reduced
to Rs.100 million bringing many more loans within the
150 per cent risk weight bracket from April 1, 2009.
Hence by getting loans rated, banks will be able to save
capital on loans in the higher rating categories.
A consequence of this mayhem is ruthless competition
among banks for highly rated corporate needing
lower amount of capital which is now exerting pressure
on already thinning interest spread. If a bank has
high quality credit exposures, it saves capital on account
of credit risk. Conversely, a bank with relatively lower
5 Supervisory Review Process refers to Pillar II of the Basel II accord. Pillar II requires Regulator to ensure that each bank has sound
internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its various risk as identified under the
new accord.