The Chartered Accountant

AUDITING
An ASSOCHAM Eco Pulse study shows that the financial health of the Indian
banking system has improved significantly. For instance, this improvement
is vivid in terms of Capital Adequacy Ratio (CAR) during the third quarter
of the fiscal 2007-08. In comparison to the mandated limit of CAR of 9 per
cent, the average capital adequacy ratio of commercial banks went up to 13
per cent in financial year 2008 from 12 per cent in the previous year.
rated credit exposure has to provide more capital.
reliability of the new rating treaty
Rating is not a pre-condition for a loan sanction or for
renewal of working capital facilities. Yet a bank can insist
on a rating for the loan before sanction or renewal,
as it will help the bank in saving capital as stated above.
On the other hand, a company has the option to accept
or reject the ratings assigned to it by the rating agencies
.Once the rating is approved, a rating letter is issued by
the rating agency which is posted on its website and
carry in its monthly publications.
Rating is a lagging indicator of the credit risk and the
agencies have poor track record in this respect. There
is a possibility of rating blackmail through unsolicited
rating. Moreover, rating in India is restricted to issues
and not issuers. Encouraging rating of issuers would be
a challenge. In case of unrated sovereigns, banks and
corporate, the prescribed risk weight is 100 per cent,
whereas in case of those entities with lowest rating, the
risk weight is 150 per cent. This may create incentive
for the category of counter parties, which anticipate
lower rating to remain unrated.
Alternative Approaches
The new Basel framework provides for alternative
approaches for computation of capital requirement
of various risks. However, competitive advantage of
Internal Ratings Based (IRB) 6 approach is leading to
domination of this approach among big banks. Banks
adopting IRB approach will be more sensitive than those
adopting standardised approach since a small change in
degree of risk might translate into a large impact on
additional capital requirement for the IRB banks. Thus,
IRB banks will avoid taking high-risk loans/ assets on
its books. Also banks adopting Standardised Approach
will not be equally risk-sensitive and shall have a relatively
less capital requirement for the same exposure
when compared to IRB banks. This may result in banks
on Standardised Approach to be inclined to give loans
to high-risk clients, which have been turned down by
IRB banks. This paradox shall net result in high-risk
assets flowing to banks on Standardised Approach,
as they would require lesser risk capital for financing
such risky loans than banks on IRB approach. Hence,
the system as a whole may maintain lower capital than
warranted and become more vulnerable. What we understand
is that in quest for perfect standards, the only
universally accepted standard has been lost.
Also, developing countries like ours have high concentration
of lower rated borrowers. The calibration of
IRB has lesser incentives to lend to such borrowers.
This, along with withdrawal of uniform risk weight of
0 per cent on sovereign claims, may result in overall
reduction in lending by internationally active banks in
developing countries and increase their cost of borrowing.
historical database
Financial stability as a term came into existence just
about 12 years back when the Bank of England first
used the term in 1996; this indeed is a major push for
FS reporting. Financial stability in the banking system is
nothing but evaluating the interdependencies between
the individual banks. A large loss in a systemically important
bank is more often likely to trigger losses in
other banks in the system. The IMF has modelled this
by evaluating the Joint Probability of Default (JPoD)
of a portfolio of banks, by taking the individual probability
of default and modelling the interdependencies
using non-parametric copulas. The concept of joint
default analysis is also used by Moody’s to determine
the impact of external support on banks ratings so in a
way they are also modelling the interdependencies. The
JPoD represents the joint probability of default of all
banks in the portfolio given that at least one bank has
defaulted in the system and is thus a measure of the
Banking Stability Index. The IMF has actually tested
this on portfolio of 15 large systemically important
banks and has determined that the JPoD for this portfolio
has risen almost 10 times from mid 2007 till the
present.
6 Under IRB approach, a bank uses its internal ratings, based on the measurement of unexpected loss (UL) and expected loss (EL) derived
from four key variables: probability of default (PD); Loss given default (LGD); exposure at default (EAD); and effective maturity
(M). The banks will have to estimate the potential future loss from the exposure and assign risk weights accordingly. The IRB Approach
has been further subdivided into Foundation Approach and Advanced Approach. In Foundation Approach, a bank would internally
estimate the PD and the regulator would provide the other three variables, whereas in Advanced Approach, the bank would be expected
to provide the other three variables as well.
THE CHARTERED ACCOUNTANT 981 DECEMBER 2008